Low Global interest rates continue to drive equity markets as many of the macro impediments to global growth have been removed or pushed into the future. According to the IMF- World growth is expected to rise from 3.5 percent in 2017 to 3.6 percent in 2018. Stronger activity, expectations of more robust global demand, reduced deflationary pressures, and optimistic financial markets are all upside developments. But structural impediments to a stronger recovery and a balance of risks that remains tilted to the downside, especially over the medium term, remain important challenges.
The projections above paint a picture of consistent albeit slow growth across the world. Domestically, business confidence is strong, but business investment (ex China) still remains weak. Unemployment has tracked downward but underemployment (those on part-time work looking for more work) remains high. Job vacancies are trending downwards. Wage growth remains muted globally, which explains the historically low inflation figures.
Since the GFC we have seen unprecedented amounts of monetary policy that has resulted in record low global rates. Despite the amount of stimulus pumped into global markets inflation remains stubbornly low although we have seen a slow rise over the last 6 months. (See chart below)
The questions is: – can inflation continue to rise despite of the end of Quantitative Easing (QE)? The answer is likely to be yes, but very slowly. Advancements in technology has already made some jobs redundant. Wage increase pressure, despite strong employment numbers is lacklustre. Many have argued that because of technology many workers are now “under-employed” i.e. can only find part-time work. Looking forward this is likely to only get worse.
In a discussion paper, by Colin Pohl (Startup 360), he argues that 47% of jobs in the United States are likely to become obsolete in the next 10-15 years. There are counter arguments that technology also creates jobs but the lack of wage growth seems counterintuitive. A study by Frey & Osbourne produced the following table. In the last few years we have seen the huge changes in food service (think McDonald’s automated ordering counters) and retail (automated checkouts) which certainly back the study’s findings. Rick Rieder, Investment CEO of funds management behemoth Blackrock told us recently “Today, massive technological disruptions and long-term demographic trends are remaking the inflation landscape, and we believe both investors and policymakers need to abandon an overly rigid view of price change”
What does this all mean? If we are to live in a low interest rate world it means that equity and property valuations will and are being priced differently. Looking at the S &P 500 presently, there have only been two times in history where valuations have been higher- 1929 & 2000. Neither ended well! The only valuation that I can find that substantiates the current high levels is relative earnings.
The below graph (Blackrock) shows that based on relative earnings yield (earnings per share divided by the share price, or the inverse of the price-to-earnings ratio) stocks are cheap. While in absolute terms they are extremely expensive.
Former FED Chairman Dr. Allan Greenspan was recently quoted as being relaxed about the current equity risk premium, he is however, worried about how low the TIPS yield is. (Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation because the principal to be repaid increases by the rate of inflation) Greenspan said “By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace,”
In other words, every time the Fed lifts rates, shares will look more and more expensive unless earnings can increase at the same rate (unlikely). Those invested in long term bonds may face large losses. However given that QE is ending and core CPI in the US last quarter was weak, the US may lifts rates much slower than many anticipate- at least for the short term. Economists continue to be surprised at how often they are surprised by weaker than expected numbers! Therefore, if we continue to muddle along with slow economic growth, equities should continue to outperform bonds.
China and the little Aussie battler.
Given that the US is slowly lifting rates and Australia seems in a holding pattern likely to wander well into 2018, why is the Aussie dollar rallying? In my opinion it has nothing to do with rhetoric from the RBA but all to do with increasingly bullish figures from China. As the graph below from UBS shows it is Chinese imports that is most responsible for the Global Reflation we are currently seeing.
Capital expenditure in China has picked up markedly in 2017 after 3 flat years. (First quarter up 5.6%). An analysis of the Capital Expenditure (Capex) shows that Capex is shrinking in areas with excess capacity such as steel, materials & Telecoms to essential manufacturing and consumer facing industries and therefore is likely to be far more sustainable. Like most of Asia, due to our trade ties, strong economic figures in China will assist our local economy and dollar. Unfortunately for us, a very strong dollar is not ideal. Our goods and services become more expensive which is not helpful when we are looking to compete globally and create jobs, especially in large employment groups such as tourism and retail.
The last 12 months have been good for equity investors and poor for conservative investors with interest rates so low. The year ahead promises similar macro positions and therefore one would expect considerably better returns in equities than bonds. Equity valuations in some markets are stretched and history shows that at some stage in the future there will be volatility. At Hudson Gore we will continue to monitor conditions and advise accordingly. As always if you have any queries do not hesitate to contact me.