Society has reached an important inflection point on several fronts which will have profound implications for global equities and investors. We have reached the end of globalisation as we have known it since the early 1980s. Large imbalances can be seen across the environment, income distribution, credit and the global supply chain.
Investors are buying the Fed put
The OECD’s leading indicators on the global economy are still declining with April’s numbers marking the 17th consecutive monthly decline. The global economy is at its weakest point since July 2008 and the probability of a recession is still elevated and not fully reflected in equity valuations. South Korea, one of the world’s economies most tuned to globalisation, is showing significant weakness with its leading indicators declining for 23 straight months in April, and to levels not seen since early 2012. The South Korean economy has historically been one of the best indicators for the global economy, so we expect more pain to come in the second half of the year.
The only major economy that has turned positive among the OECD’s leading indicators is China. This is not a big surprise, given the recent major improvement in the credit impulse, although it is still negative. But China’s improved industrial sector is driven by a major national push from the government and is likely driving domestic demand more than global demand. Meanwhile, the country’s car sales (which serve as a proxy for the consumer sector) remain weaker than at the bottom of the financial crisis, highlighting elevated uncertainty among Chinese consumers. In fact, May data shows that sales growth weakened again.
Added to the current economic realities is stagnant profit growth among global companies, an escalating technology war between the US and China, likely higher input costs for companies due to “green policies” and an increasing attack on inequality, which will lead to higher wage growth and, therefore, dent companies’ profit margins. How do investors reconcile all these risks with high equity valuations?
Historically, equities have done worse than bonds when global leading indicators have been below trend and declining (also called the recessionary phase), but this time equities have defied gravity and continued their ascent. The only sensible explanation is that investors are buying the Fed put and betting on low inflation, stable growth, no financial crisis and that a global supply chain shock from the current US trade policy can be avoided. This is both foolish and dangerous for investors, and investors who agree in this view could consider an overweight in bonds and underweight in equities. Most important for equity investors is to steer clear of the value trap called European stocks.
Historically pro-cyclical countries, such as South Korea, Brazil, South Africa, Australia, the US and Hong Kong, have delivered the best returns when the economy has been in a recessionary phase. In terms of sectors, this means overweight information technology, communication services, consumer staples and real estate.
Equities reflect unheard-of confidence
Equity valuations reflect the present value of future cash flows which is primarily a function of current cash flows, growth expectations and the discount rate. This naturally leads to considerations of cash-flow generation in both the short and long term. With equity valuations at their current level, investors are showing confidence in short-term cash flows not declining materially, hence a bet on no recession, and on stable long-term growth. This belief is best reflected in US equities which are back to elevated valuation levels characteristic of late-cycle behaviour.
The probability of recession is much higher than what global equities are currently reflecting, with the yield curve and leading indicators sending the strongest warning signals to investors. But history has often shown a final bullish move in equities despite clear evidence of an incoming recession. This is exactly what we are witnessing today. The Fed put is used as an excuse to buy equities as it presumably increases the equity risk premium. But history shows that the first rate-cut is often a reliable signal that a recession is coming which reduces short-term cash flows and raises return expectations as investors become more risk-adverse. The short term is not correctly discounted in equities, based on our forecast, but it is the long-term expectations that we believe make the disconnect between equities and reality the biggest.
Long-term profit growth expectations are likely too high. As the pendulum swings back from globalisation, inequality, the environmental degradation and debt saturation, companies (especially technology companies) will likely face more regulation, higher taxation related to carbon emissions, higher labour costs and more local production due to rising nationalism. These factors will act as headwinds for companies, though some of it can be offset by increased fiscal spending driving up nominal growth. But this policy trajectory points to much higher inflation, on top of higher inflation from a less global supply chain, which will ultimately be the inflation tax that companies faced in the 1970s.
Input costs will rise dramatically
Companies have enjoyed a remarkable expansion in profit margins during the great globalisation starting in the early 1980s. Driven by lower funding costs, weaker labour unions, weak anti-trust regulation, digitalisation and lower input costs from historically low commodity prices and cheap labour in Asia, global companies — and especially US companies — sit on the fattest profit margins in recent history.
As policymakers will soon find out, the current monetary policy has little power to restore economic growth at a debt-cycle peak, so they will quickly move to the next natural extension of policy moves called Modern Monetary Theory — a tighter linking of fiscal and monetary policies. Governments will likely be forced to increase spending dramatically to close the infrastructure gap, but also to deal with the transformation of society to lower the impact on the environment from economic activity and finally to address the issue of inequality.
The consequence of significantly higher fiscal spending is likely higher commodity prices and higher inflation. The inflation component will also get a boost from the global supply chain being rolled back to a more local arrangement due to the breakdown of the multilateral trade framework initiated by the Trump administration. These factors will drive up input costs for companies, pushing profit margins back towards their long-term average. Higher inflation will be the most damaging factor for equity investors, as the 1970s showed: equity investors had a negative real return in 1969-1982.
Investors face large structural breaks, low expected returns across most asset classes and increased volatility, as the volatility compression brought about by monetary policies since 2008 will likely end with higher volatility restoring symmetry in the risk-payoff structure. In other words, we expect the next 10 years to be the most difficult for investors to navigate and to deal a big blow to passive investing as well. There has probably not been, in recent time, a better starting point for active investing, as the one-way street of monetary policy and globalisation that benefitted passive investing has ended. The structural breaks ahead will also be difficult for computer models to handle, restoring humans as a critical element in the investing process.
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