‘The US economy is red hot.’
Ethan Harris, Global Economist, Merrill Lynch
Two primary issues continue to dominate the global political economy. Firstly, the exceptionalism demonstrated by the US economy and secondly the US trade war with China.
Turning to the US economy firstly, nominal GDP growth appears to have run at 4% for both the second and third quarters of this year. Final sales have been unable to keep up with demand, putting downward pressure on inventories. Despite an increasing scarcity of available workers, employment growth has accelerated over the past year. Normally, growth tends to slow late cycle, as central banks try to avoid inflation blowing up. However, the Trump administration passed a significant tax stimulus and it is thus the first time since the late 1960s that tax cuts have passed Congress when the US is at full employment. This effect stimulated demand, but supply has been slower to react, creating more pressure on capacity. The Federal Reserve (Fed) raised rates at the end of September, but still considers them to be lower than ‘neutral’ (a level when they neither stimulate nor contract the economy). If US rates are too low and inflation appears, then it may force the Fed’s hand to raise interest rates more aggressively and that may have a detrimental impact on asset prices. As the third quarter gave way to the fourth, we saw the yield rise on the 10 year bond comfortably above 3% and equity valuations subsequently fall back. We wait to see if the strong pace of corporate earnings growth carries from second quarter to third quarter results, announced through October.
It is worth noting that the valuation of shares is driven by three main factors; the rate of growth, the discount rate, and the Equity Risk Premium (what you as a shareholder want given the risk a company can go bust). The growth rate forecast is the result of subjective analysis; the Equity Risk Premium is a more objective observation, but hugely prone to swings in sentiment, which leaves the discount rate as the most concrete valuation driver. The key global one is the US discount rate, with the yield on 10 year Treasury bonds being the number. As we noted previously, this has risen and impacted stock valuations, but if earnings are consistently strong, this will blunt the impact of rising Treasury bonds yields, assuming they are climbing due to the overall strength of the US economy and not inflation. Empirical work from Merrill Lynch suggests a 5% yield on the 10 year Treasury bond is when there are likely to be wholesale shifts out of stocks into bonds. We are materially below this yield level.
Secondly, let us consider the US trade war with China. The view of the US Government now appears to be intent on removing China’s involvement in the global supply chain by forcing multinationals to ‘re-shore’ production back to the US. By facilitating a new trade agreement with Mexico and Canada, discussing a deal with the EU and now Japan, it may leave the Chinese somewhat isolated. Unfortunately, there are serious gaps of cultural understanding between the current approach of tough negotiating and how any type of compromise would be perceived in Asia. Optics are very important. As the US has not allowed China an avenue to ‘save face’, and there’s no possibility for Beijing to give any ground that allows Trump to claim a victory over China suggests we will see the second round of tariffs come into force in January. This leaves open the prospect of a policy shift, which for the Chinese would be depreciating the currency setting off a disinflationary impulse. The consequences of this were last seen in global markets in the Summer of 2015. On balance, it is still in China’s interests to resolve this dispute with the US, given it will have a larger impact on its economy, than it will do on the US and globally it is relatively friendless.
We are some way past the synchronised global growth seen in 2017, but we are not at this point staring down the barrel of a recession, for the US either. Alongside the above trade war concerns are worries over Brexit, Italy and the oil price, after sanctions are imposed on Iranian oil exports in November, by the Americans. Principally though, our focus remains on the Fed. US economic expansions do not die of old age, but have overwhelmingly been ‘killed’ by the Fed, following periods of the economy overheating that brought on inflation and caused them to increase interest rates aggressively. If the Fed believes that inflation expectations are well anchored and chooses to ignore any pick up in inflation due to an oil price rise (towards $100 a barrel) as being transitory then the level of monthly employment will be the critical gauge to follow moving into 2019. The Fed will want to attempt to take sufficient heat out of the economy to dampen any inflation concerns by gradually raising rates so unemployment stops falling, and then starts to rise. Given the long lags between the point of raising interest rates and their impact on an economy, there is little guarantee that the Fed will not go too far, raising rates more than needed or proceeds too slowly, forcing them to play catch up, increasing them in an aggressive manner. On average, UBS research says the US stock market discounts a recession seven months before it occurs. Even if one is probable in 2020, this still remains someway off and companies with a bias towards value over growth with good dividends, would be the bedrock of equity exposure when bonds are still likely to be a poor alternative, until such time as yields reverse downwards predicting the next rate cutting cycle.