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Listen to Henk's views on the current state of the markets.
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Hello there. It’s Thursday the 25th of October and this is the Barclays Market Intelligence Report with Henk Potts. It’s been a turbulent time, Henk, in financial markets over the last couple of weeks. How concerned should we be about the outlook for the global economy and risk assets?
Henk: In order to understand where we are today, we need to think about economist expectations as we came into the year. Economists described it as the ‘Goldilocks economy’ - not to hot, not too cold, just right.
Remember when we talked about synchronized growth in the global economy for the first time for many years. It wasn’t too reliant on a single geographical region, industry or source of demand. There were moderate levels of inflations, there were high levels of employment, there was low energy prices. The forward looking indicators were positive. Central banks were remaining accommodative. But like Goldilocks, some of the economists forgot about the risk of the bears coming up and disrupting the party.
The bears have been somewhat bigger and somewhat louder than anticipated in the first part of this year. They come in the form of trade wars, increasing global tensions surrounding Iran, Syria and Russia. Perhaps more recently we have to add Saudi Arabia into the mix as well. Along with the political instability and economic challenges, that we’ve seen in the likes of Italy and Turkey, rising inflation expectations, particularly in the US, are putting pressure on the Federal Reserve. The stronger US dollar has broad ramifications, of course, for global financial markets.
Brexit continues to be pretty disruptive. So, there’s lots of macro things that have been playing out and generating this wave of uncertainty. But I think despite headlines, I don’t think investors need to be too pessimistic about the outlook for the global economy or indeed abandon risk assets just yet. After a poor performance in 2016, US activity picked up during the course of last year. It got really strong momentum as we have gone through this year.
The US consumer, as you know, is in really great shape, benefitting from very low levels of unemployment. Pay growth has been picking up. Tax cuts have been boosting disposable incomes. We also know that investment from companies is strong in the United States and indeed they’re getting that sugar rush from that fiscal stimulus program, so we expect US growth to be somewhere around 2.8-2.9% during the course of this year and somewhere close to around 2.6-2.7% next year. So, a strong performance there.
European growth, we should remember was the strongest in a decade last year at 2.5%, has been a little bit weaker during the course of this year. There was weather disruption at the start of the year. Strikes have posed a problem in terms of Europe. There has been some element of weaker external demand alongside that. If you look at private consumption, private investment has been below expectations. But we still expect Europe to grow at a 2%+ growth rate this year, maybe 1.8% or so if you look out to next year.
Even emerging markets, who have had a pretty rough ride over the course of the last few months, are adding to that global growth environment. We are only going to see a moderate slow down coming through from China.
We’re still forecasting global growth somewhere close to 4% during the course of this year and 3.8% next year. Much better, perhaps, than those headlines on the screen would suggest.
Henk: Well Italy’s government, of course, came into power on the back of its anti-establishment, Euro-skeptic, popularist stance, promising to slash taxes, increase welfare payments, increase infrastructure investment in an effort to kick start the economy and radically reshape its relationship with Europe.
To that end, the government proposed its budget to the European Union that included a 2.4% budget deficit - much, much, higher than economists have been anticipating. Potentially, of course, breaking EU rules. It certainly doesn’t address the need to cut the structural deficit by the required amount under those EU regulations.
The European Commission looked at the draft and rejected it and ordered Italy to submit a new one in three weeks or face disciplinary action. Which means that they could actually get an unprecedented fine of two tenths of 1% of the GDP which we know would do very little to improve Italian-EU political relations or indeed help Italian finances. Markets have been reacting to that disruption.
Italian bond yields have surged 10-year yields rising above 3.5% Italian sticks have been sold off and the euro as been under pressure as well. Actually what’s important for the market is, what is the read-through in terms of Europe? What is the risk in terms of contagion?
Italy has specific economic challenges. We’ve seen anemic economic growth there. Growth in Italy last year was 1.5% compared to Europe, as we said, at 2.5%. Expectations for growth in Italy this year were 1.1% and it’s a similar figure for next year.
We’ve seen low productivity growth - the lowest amongst the G7 economies in the years after the financial crisis. They’re dealing with that huge debt to GDP ratio - 132% GDP ratio – the second highest in the eurozone after Greece, elevated levels of unemployment. Unemployment in Italy is 9.7% today. The European average is 8.1%. House prices, we know, in Italy have fallen for six consecutive years. There have been low levels of foreign direct investment. That’s all posed problems specifically in terms of Italy.
So when you look at that, as I say, the contagion risk still looks low, the standoff with EU and markets pressure, I think, has been rising. Potentially that could escalate. That may result in a new government needing to be formed or indeed a return to the polls. Actual risk from Europe from Italian disruption still looks reasonably low for us.
Henk: Well, one of the big risks under a Trump presidency that emerged during the course of his campaign was his protectionist stance and those words quickly turned into actions over the course of the past few months. It’s no surprise, of course, that it’s turned into a full blown trade war. Targeted countries have retaliated in terms of putting tariffs on exports into the United States into their countries as well.
Trade wars are bad news for the global economy. They weaken projected trade volumes, discourage businesses from investing. They lead to a rise in producer and consumer prices which in turn has an impact of a modest squeeze in terms of private consumption, has the potential to stoke inflation and a drag in terms of growth.
There are regions that are more affected than others. Asia is the most vulnerable, of course, to a trade war, specifically China – the world’s largest exporter. China exports something like US$2trn to the global economy. US$600bn goes to the United States. Sectors that are seen as vulnerable include agriculture, transportation, industrial machinery and technology as well.
When it comes to China specifically, we’ve recently had data coming through from them. Third quarter growth came in at 6.5%. That was down from 6.7% that we saw in the second quarter. It’s the weakest performance that we’ve seen since the depths of the financial crisis in 2009.
Underneath that headline number, you do start to see elements of the transition that’s taking place in terms of the Chinese economy, as it moves away from industrial production and fixed asset investment to become a more domestically focused and consumption focused economy. Industrial output fell, growth fell to 5.8%. Fixed asset investment - 5.4% but retail sales rising strongly at 9.2%.
Trade wars are important for China, of course they are. US protectionism has been putting downward pressure in terms of its economy. The US announced plans to implement tariffs on US$250bn worth of exports and we think that could lower Chinese growth by four tenths of 1%. If you take an average of maybe of a 20% tariff across all Chinese exports to the US, perhaps it will reduce Chinese growth by a further half of 1%. So the numbers are becoming significant. Economists have been taking account of those.
Alongside that, there’s a real deleveraging process taking place in China that we should be aware of. Chinese capital markets are relatively under developed, therefore companies are reliant on indirect financing. Chinese credit growth has risen rapidly in recent years, pushing up leverage to historically high levels. There are lots of concerns around the size of the shadow banking system. So a deleveraging process has been taking place particularly in State-owned enterprises. There have been measures to try and reduce the risk of bubbles in the property sectors there has also been financial market reform as well.
I think there’s a real balance act taking place among Chinese authorities at the moment, looking to mitigate the risks of trade wars deleverage the economy but also maintain its growth profile. They’ve certainly proved themselves ready, willing and able to stimulate growth as and when it’s required. We’ve seen reductions in the reserve requirement ratios, tax cuts, infrastructure investment.
So, we still remain pretty optimistic that China will get close to those growth targets during the course of this year. Growth is somewhere between 6.5-6.7% for this year and 6.5% if you look at 2019 so I don’t think we’re overly concerned about the impact longer term of what trade wars will mean for China, particularly as they go through that transition.
Henk: Well, that’s another area that has been unnerving investors of course. The Fed began hiking rates back in December 2015 from near zero levels. They hiked eight times between 2-2.25%, saying they are determined to normalize policy. That has been driven, I think, by strong growth, ammunition for the next time there’s an economic downturn and rising inflation expectations. We think the Federal Reserve will be forced to hike rates a bit quicker than the markets have currently priced in.
We forecast one more hike this year, coming in December and one per quarter in 2019. So, we’re very quickly talking about the normalization of policy, with US rates getting back to 3.25-3.5%.
One of the concerns, of course, over that fiscal stimulus program is that it overheats the economy putting more pressure on the Federal Reserve and that’s one area markets have been concerned about. We think the economy is probably strong enough to withstand these moves but it’s going to be a reasonably close call.
Henk: Well, if you look at emerging markets in the years after the financial crisis, a huge amount of liquidity was created. That liquidity had to find a home. It had to find a return. Many cases washed up on the shores of emerging markets who were all too grateful to have access that liquidity to invest in projects and stimulate growth. But, as we’ve been talking about, the world is starting to change.
That liquidity is being mopped up. Higher US interest rates the stronger US dollar has led to the repatriation of funds, concerns around the escalating trade war has also led to capital outflows coming through from emerging markets. Now, clearly we’ve seen problems in some key emerging markets.
I think investors are looking for specific elements to see if other countries could be vulnerable to that. They’re looking for large hard currency debt piles. They’re looking for high financing needs. They’re looking for elevated levels of inflation. They’re looking for political instability and erratic policy decisions. That’s why we’re seeing pressure on the likes of Turkey, but also South Africa, India and Indonesia for example.
But actually, when you look at a broader range of emerging market economic indicators, actually they still look reasonably stable. I think governments across emerging markets have been operating to a more conservative fiscal policy than we have seen in the run up to the previous crisis. They have been building up their external buffers. There’s higher levels of foreign exchange reserves. They have been narrowing their current account deficits. There’s less dollar denominated debt out there and debt maturities have been pushed down.
So actually, when we look across emerging markets we see specific problems in individual countries. We don’t see a broad based theme that’s going to destabilise the entire concept of emerging markets.
Henk: No, I don’t think so. Actually there has been some nervousness as we’ve seen the numbers being reported, but I think the numbers still look quite good quite frankly. If you look at analyst expectations, they still expect earnings growth year-on-year for S&P companies to come in at the quarter at 19.5% - the third best performance that we’ve seen since 2011.
If you look at where that growth is coming from, it’s coming from the strong US economy. It’s benefiting from tax cuts, of course, but high on energy and material prices. Revenue growth is also strong, growing above 7%, so it’s not simply the impact of tax cuts coming through.
Analysts expect earnings growth of 20% for the full year for S&P 500 companies, but it’s not a one year wonder.
If you look at next year for example, expect another 10% earnings growth, the year after that another 10% on top of that, so I think the corporate position still looks bright when you look at the United States. Valuations have actually come down, certainly given the weakness that we’ve been seeing in markets, we’ve seen the forward price earnings ratio of the S&P 500 fall below 16 times.
Remember at the start of the year we were trailing above 18 times. In fact, we’re now below the five year average strand, 16.2 times, so nothing really concerning us when it comes to valuations when it comes to the US or indeed that profitability growth.
European shares have underperformed the US significantly during the course of this year. We still think that’s an opportunity for investors benefiting from a steady growth profile and continued central bank support and that rising profitability.
If you look at equity market fundamentals, they still look pretty attractive. Less demanding valuation in Europe – 13.7 times forward multiple. The five year average 4.6 times. Earnings growth 6.5% this year, 10.3% if you look out to next year and a higher dividend too that still remains attractive at 3.2%, so I still think there are fundamental building blocks for clients’ portfolios and they should continue to invest in those areas.
Henk: Well we have seen significant falls in terms of the European banking sector. There’s no doubt about that. We’ve seen investors, I suppose, reacting to political, economic turmoil in Italy and Turkey. Banks are vulnerable to sovereign weakness. They required to hold significant amounts of government bonds for regulatory reasons. Disruption can also impact their cost of funding.
Banks have been impacted as well by prolonged low interest rates which have depressed net interest margins. They’re taking longer to deal with poor conduct and legacy issues than anticipated and of course there’s been individual issues for banks as well that has held them down. Deutsche Bank is probably a good example of that. We do think the European banking sector is an attractive place for investors to put their money.
The recovery in Europe is leading to falling unemployment, growing business confidence, all of which is reducing loan growth and reducing the risk of non-performing loans. Banks, you should remember, are in much better shape than they were during course of the financial crisis. If you look at capital, if you look at solvency, if you look at asset quality, they’ve all improved. Weaker institutions have at least been partially restructured. Inter-bank markets are showing very little signs of stress. They’re very attractive valuations as well.
The European banking sector price-to-book level has been trailing down at historically low levels. I think markets have been focus on short-term factors rather than long-term prospects, share prices are falling, earnings growth is rising in some ways that feels like that is a mispricing of risk which could create an opportunity.
Henk: Well, we’ve moderately reduced our pro-risk stance, taking some allocation out of US equities even though I think, as we were talking about, the picture still looks very stable there. We’ve put some of that allocation into cash, keeping our powder dry for opportunity.
We have also been looking for some opportunities in terms of emerging markets as well, but as I say, we have been overweight in terms of developed markets and emerging market equity. We think investors will be rewarded for holding their nerve. There’s certainly no need to panic despite some of the headlines, despite some of these big red numbers we’ve been seeing on the screen.
Henk Potts from Barclays – thank you very much. We hope that you’ve found this podcast useful.
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