Wednesday, 17 October 2018

Pessimism on global growth reaches November 2008 levels; is it justified?

The WSJ reported this morning that, quoting BoAML data, "fund managers are the most pessimistic they have been on global growth since November 2008".

Now I find this very interesting. Global markets were a day ago down more than 6% MTD, and outside of the US, markets have been pummelled this year across EM (emerging markets) and Europe. Investors have been gripped by trade war fears, rising short and long rates in the US alongside tightening Fed policy, a rallying USD (harming EM, and creating fears around USD-denominated indebtedness in some of these nations), as well as rising nationalist politics in countries such as Italy. This has created a pervasive sense of malaise, and sent markets into a tailspin.

I've written in the past about how heightened emotion corrodes peoples' ability to think rationally, and for many market participants, seeing their portfolios drop by 6% in a matter of weeks can trigger all kinds of self-preservationary human instincts that completely undermine rational thinking. Now I'm not going to pretend I have a crystal ball - I don't - and there are a lot of risks out there, as there always are. But what can be done is to take a deep breath and a step back and consider some of the known facts as dispassionately as possible, and when one does so, it appears to me that investors are reacting in a similar way to RBS's hysterical call in February 2016 to 'sell everything' - almost exactly at the bottom, before a period of 'synchronized global growth' suddenly developed, and global markets rallied very significantly throughout the balance of 2016, until January 2018.

First, some context. In November 2008, the world was being gripped by one of the worst financial crises since the Great Depression, and economies throughout the developed world were in free fall. Many large financial institutions either failed or were at risk of failing. Uncertainty reigned as a 'regime change' occurred in investors' understanding of credit cycles, as the Fed's 'great moderation' dictum, which markets had bought into, was proven startlingly naive and ignorant. Oil prices had plunged 75% in a matter of months. China's economy was sharply slowing and commodity prices collapsing, and people didn't know what might occur. And massive inter-European imbalances were in the early stages of creating what would later become a European sovereign debt crisis, and a veritable depression in many Southern European countries, such as Greece, Spain, and Italy.

So how does today's reality compare to that? Firstly, on any objective metric, the US economy is booming. There is such visceral hatred of Trump that people are not prepared to look objectively at the actual economic outcomes of his policies, which are focused on boosting US competitiveness (corporate tax cuts, tariffs, and deregulation), and improving the bargaining power of labour (immigration policy, and policies to support domestic manufacturing).

Record levels of job creation currently exists; median real wages have started to rise for the first time in four decades; corporate profitability is booming; and official unemployment continues to plumb new lows (albeit 'extended' unemployment measures which adjust for low labour force participation, still peg unemployment at closer to 8%, providing ample room for further gains). Robust (potentially too robust) fiscal stimulus is being supported by incipient manufacturing repatriation, a booming shale oil and gas patch as oil prices breach US$80/bbl (Brent), and the US's powerhouse of a tech industry continues to deliver robust growth and innovation. I've said it before and I'll say it again: the main risk with respect to US growth at present is overheating, not a trade-induced recession.

Meanwhile, pervasive bearishness now exists on the outlook for the Chinese economy, as trade war rhetoric has pervaded the financial news, while the Chinese economy has also slowed this year, after a period of significant acceleration during 2016-17. However, perceptions of China have not kept pace with reality. China is still perceived by many as being merely a mercantilist exporter to the US. That was much more the case 10-20 years ago, but China has changed a lot over the past decade. Its sources of growth have diversified; exports have become less important; and its current account surplus has significantly shrunk, from in excess of 10% in 2007, to approximately 0% today.

Chinese exports-to-GDP are about 20%, and only about 20% of those exports go to the US, so US-exports-to-Chinese-GDP are only about 4%. Furthermore, this 4% also includes the full nominal value of exports with relatively low 'value added' share (e.g. smartphone assembly).* The world is less unipolar now than it was 10-20 years ago - the US's share of global GDP has continued to shrink, and this has resulted in China's export markets continuing to diversify. This trend will only increase in time.

China's growth has also pivoted over the past decade to being driven less by exports, and more by domestic investment and (now) rising consumption, reducing its singular reliance on manufactured exports to drive growth (indeed low value manufacturing has been migrating to nations such as Vietnam for some time now, which are increasingly competitive as Chinese labour costs rise). Instead, a big part of China's YTD slowdown reflects deliberate policy measures to curtail credit growth and reign in credit excesses (including measures, for instance, to bring shadow lending back onto bank balance sheets, and reign in local government borrowings). This slowdown is therefore deliberate and self-inflicted (albeit credit curtailment was required at some stage).

Little discussed is the fact that China's credit growth has decelerated sharply over the past 5 years to levels that are now at only approximately 1x nominal GDP (i.e. 'sustainable', yielding stable debt-to-GDP ratios). In response to both the recent economic slowdown, coupled with US trade measures, the Chines authorities have once again begun to stimulate, and this is likely to support fixed asset investment and commodity prices in the short to medium term. This is perhaps why iron ore prices have risen 20% over the past few months, while other commodity prices have also held up reasonably well, despite the rest of the investment community busily preparing for armageddon.

China remains one of the largest structural growth stories of our generation. There are risks, of course - particularly on the demand side - but the country is doing everything right from a supply-side perspective to boost productivity to an extent that will likely allow the country to eventually reach developed-world levels of productivity. Furthermore, as a country with a long-standing historical current account surplus, the country's growth and rising debt levels have been largely 'internally funded', while the state controls the banking/financial system. This makes an uncoordinated credit crunch/liquidity cease up vastly less likely than either in the US GFC, or in emerging market balance of payment crises experienced by countries such as Indonesia during the Asian Financial Crisis.

With the country now stimulating, there is actually a reasonable chance China speeds up from here, and if it does, this will also provide support for commodity prices, which will aid the growth outlook and current accounts of commodity-producing emerging markets such as Indonesia, Brazil, and South Africa. Furthermore, countries like India remain on a robust structural growth path, aided by reform and growth off very low levels of GDP-per-capita, while China's "One Belt, One Road" policy also promises to continue to support accelerate infrastructure development (with associated funding) in many emerging markets, from Central Asia to Africa.

Next, what about the fact that oil prices are now above US$80/bbl? In early 2016, everyone was worried plummeting oil prices, which reached almost US$25/bbl, were going to hammer global growth, as O&G industry investment was curtailed, and the many oil-producing emerging markets in the world suffered severe budgetary pressures. By the same logic and for the same reasons, rising oil prices ought to be a significant global economic stimulus. Countries as diverse as Russia, Nigeria, the various Gulf States, Norway, and Kazakhstan (and dare I say it, Venezuela), are going to enjoy a huge economic stimulus from the recent 60% surge in oil prices vs. 2017 levels. This is seldom discussed.

And what about Europe? Far from being late cycle, Europe is still in the relatively early stages of a recovery from a deep, deep downturn. It has taken a decade, but the continent has, for the most part, largely eliminated the major imbalances that plagued the Bloc in the aftermath of the GFC, and after a extremely challenging decade, is finally starting to show signs of sustainable growth. The Euro area now enjoys a 2.5% current account surplus, which will likely rise further on account of recent Euro weakness, while many peripheral European states are also now reporting current account surpluses (Italy has a current account surplus of 2.8%, and Greece's current account is also roughly in balance, down from a peak deficit of 15%). Government deficits in peripheral states have also been reduced, with even Greece now running a 3.5% of GDP primary surplus (before interest payments). Unit labour cost differentials between Northern and Southern Europe have also been largely corrected.

This is resulting in unemployment rates continuing to trend down across the continent, and especially in the South. Greece, for instance, is now growing by 2%, as it finally emerges from a decade long depression. Unemployment has fallen from 27% to 18%, property prices are rising, and banking system bad debt formation is negative. In short, the outlook for Western Europe is arguably as strong as it has been in over a decade.

Meanwhile, many Eastern European and CIS economies are growing very strongly, as they embrace free market policies and reform, and develop off very low bases of GDP-per-capita. Economies such as Georgia are now ranked within the top 10 nations in the world in terms of ease of doing business and corruption, and yet has a GDP per capita still in the US$4-5k area (growing at 5%). There is a long way to go in many of these flourishing economies.

What about rising right-wing nationalism in Europe? While this contains some risks - particularly long term - at this stage it merely reflects, for the most part, a push back against uncontrolled migration, which is a policy discussion that needed to happen at some stage, but which Brussels refused to entertain. Italy's Matteo Salvini has been quite clear that he does not want to leave either the EU or the Euro, but merely to reform it from within, and make it more democratically accountable to member nations who feel the legitimate concerns of their citizens are being ignored. With anti-immigrant sentiment now also rising in countries like Germany, a resolution on this issue seems quite likely. Recent ructions in bond and stock markets in places like Italy also reflect them pushing for more fiscal stimulus, and an end to a decade of Brussels-mandated austerity - policies that in the ordinary course would actually be good for short term growth (albeit at the cost of greater risks to government debt sustainability long term). Savlini's policies actually have a lot in common with Trump's policies, which have been good for US growth.

What about basket-case economies such as Turkey? The Lira has already recovered some 25% from its lows, which were hit on the exact day I wrote an blog article arguing a capitulation point may have been reached. Turkish bank share prices have already rebounded more than 50% from their lows in USD. Turkey has not only raised short rates to as high as 24%, but has now moved to a small current account surplus (from a 6% deficit), as imports have fallen and exports surged following very significant real currency depreciation, just as textbook economics would suggest would happen. Growth has already sharply decelerated but is probably not too far from bottoming, as the majority of the necessary adjustments to external imbalances have now already been forced by markets. It seems silly, to me, to worry about the Fed hiking from 2% to 3%, when short rates in Turkey are already 24%. The Turkish economy is already feeling the impact of extremely tight monetary policy.

There are some exceptions to the relatively upbeat outlook. I am bearish on the outlook for the Australian, Canadian, and NZ economies, which appear very late cycle and where growth has been supported in recent years by housing and credit bubbles which appear to now be rolling over. At worst, there could be financial crises in these countries. However, they are not of a significant size to the global economy. I also believe there is currently a bubble in private-market/VC funded tech, which will likely burst at some stage and hit investment and jobs in the Valley (and elsewhere).

The outlook for the UK is also questionable - I tend to think that because the EU/EC wants to make an example out of the UK, it has every incentive to frustrate negotiations and force 'hard' Brexit onto the UK. However, the impact will probably be significantly mitigated by a sharply-weaker Pound, as has already been the case to date.

In short, I don't see much justified cause for pervasive doom and gloom, let alone believing the outlook is as bad as it was in November 2008 (a great time to buy stocks, incidentally). This does not mean there are not important risks - there always are in markets. The US could seriously overheat, resulting in galloping inflation and the need for the Fed to tighten drastically. That would be a disaster for many economies and asset prices (although far from all - high current account surplus countries should still do well - Europe should be fairly well insulated, as would be economies like Russia and China). However, there are also many more benign scenarios, one of which would be a repeat of the huge 2016-17 relief rally post the 2015-early 2016 sell-off on global growth fears, as trade war fears ease and investors react to evidence the global economy is actually speeding up.

Time will tell. Definitive predictions are impossible, and risks certainly exist. But in my opinion, people are letting their emotions colour what should be a more rational assessment of the probabilities of various outcomes, and the idea that the outlook is now even remotely as bad as it was in November 2008 is completely ludicrous. This, in turn, suggests that there is now a significant gap between sentiment and reality, which suggests that now is likely a reasonably good time to buy. To be sure, asset prices might underperform economic growth if interest rates continue to rise - particularly in markets such as the US that are relatively expensive, but that's a different issue, and there are also large parts of global markets (such as HK/China, and Russia) which are startlingly cheap. It's a good time to be investing, and a global, opportunistic value-oriented stock picker, in my opinion.


LT3000


*I highly recommend Platinum Asset Management's 3Q18 investor commentary, for a further discussion of this issue (see CIO Andrew Clifford's letter). I have long considered all of Platinum's investment literature a 'must read'. 




4 comments:

  1. Good post - again. Much is also made of the "inverting yield curve". But the fear seems to overlook a few things.

    First, if short dated rates are rising, it's not so much because the fed is trying to control inflation, but that it is worried about an overheating US economy. So in terms of economic outlook, it's actually a positive, no?

    Then there is the fact that very short dated US rates are still substantially below long rates, and indicate a much steeper curve than if one uses 2-year bonds as the reference. And it is the shorter dated rates that provide banks with the necessary lending margin, and thus incentive to lend.

    Then there is the fact that the global yield curve, weighted by GDP, is steeper than the US curve. And it is this that matters most to the global economy.

    So it seems to me, and I'm no expert, that everyone is in a reactive "flat yield curve is bad" mode, because it fits the current narrative, without actually thinking much about root causes or fundamentals.

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  2. Great post Lyall. I pretty much entirely agree with everything you say. US economic overheating -- and the Fed eventually tightening too much in an attempt to cool inflation -- is what is likely to bring the end of this cycle, not tariffs. And we may be still a couple of years away from that point. There are absolutely no flashing warning signs in the real economy right now. That said, a few points:

    - The US stimulus has boosted growth (undeniable) but this magnitude of stimulus late in the cycle is almost unprecedented. (The last time it happened was the late 60s, which lead to an overshoot in inflation, the Fed getting behind the curve, and then a severe downturn). It's arguably fiscally reckless. The US budget was already on a bad trajectory and this only brings the day of reckoning forward much faster. We are talking about $1 trillion plus deficits ahead as far as the eye can see. One consequence that is not enough discussed is what policymakers do when the next recession hits. There will be a lot less fiscal dry powder than what we had in 2008. The same will apply to the Fed, as rates will be coming down from a lower terminal level.
    - Even if there are 2-3 years to run in this business cycle, markets may well turn ahead of this. The impact of the US stimulus will soon peak, and to the extent markets look ahead to this we could see a lot of volatility, especially if earnings guidance becomes more cautious.
    - I agree that tariffs will not be the cause of a downturn but they could have pretty big implications for global supply chains, especially in tech where you have the added dimension of the recent reports about Chinese attempts to compromise US tech infrastructure. Those tensions are here to stay (and will probably throw up a lot of opportunities in Chinese companies that are not impacted but get thrown out with the bathwater).

    Cheers,

    Zen

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  3. Agree. The shape of the yield curve doesn't mean what it used to, given the impact of quantitative easing in Europe and Japan (although soon to end in the former), global pension demand at the long end and so on. That said, the yield curve probably will invert again ahead of the next recession. It's just hard to sort through the false positives that we may get in the meantime.

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  4. Thanks for sharing your thoughts. I always appreciate your coolheadedness.

    Now that it is a month latter, and oil is closer to 60 dollars a barrel than 80, has your thinking changed at all?

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