Every year at this time investors think about the challenges and opportunities in the next 12 months. Key inputs in the investment outlook of Australians are what’s likely in store for the US and Chinese economies, and for US shares.
Particular attention needs to be given on whether the extreme gloom on economic conditions in the US and China, and on the US sharemarket, has run too far. In my view, it has. Although it’s too early to be sure, this could be yet another false crisis.
Most times, our sharemarket follows the direction set by US shares. A US recession is always followed by a bear market in shares right around the world — including in Australia, even if, as in 2008-09, we didn’t follow the US into recession.
The recent build-up in expectations the US will slide into an early recession reflects a wide range of questions such as:
• Following the arrest of Meng Wanzhou, the senior executive of Chinese communications giant Huawei, is there a danger the US-China trade wars will escalate again after the recent truce expires or is ignored?
• Might the US yield curve, now flattening, soon invert?
• Is the Fed tightening too much given the increases in the cash rate and the reversal of quantitative easing?
• The US sharemarket has often been seen as overpriced; will share prices collapse further and cause recession?
• Could the current upswing in the US economy soon die from old age?
• Will the high gearing of US companies bring about a spate of business failures, and recession?
I believe market expectations for an early US recession are exaggerated. More likely is that the US will grow by a bit over 2 per cent in 2019, and inflation will creep higher.
US jobs growth and consumer spending are buoyant; and the budget is stimulatory (too much so?). The Fed has recently suggested a softer setting in monetary policy. (Might the Fed even leave the US cash rate unchanged during 2019 at, or a little below, 2.5 per cent?)
Also, earlier concerns of stretched valuations of US shares have eased in recent months; the much-watched one-year forward price-earnings ratio for the S&P 500 index has fallen from 18.8 times in mid-year to 15.6 times in late November, thanks to the tax cuts and the plunge in share prices.
It’s natural some investors and commentators, particularly those in or near trading desks, suggest that recession will follow the sudden drop in share prices. They emphasise the link running from shares to the economic outlook, more than they acknowledge the link from the economy to the sharemarket.
In every country, especially China in the early weeks of 2016, predictions of imminent recession became shrill when the monthly purchasing managers’ index (PMI) was reported as less than 50 points. We often hear a PMI of less than 50 indicates a contraction in the economy, and that a PMI greater than 50 signifies expansion. But that’s not correct. PMIs are a diffusion index based on surveys that ask purchasing managers whether things have improved, stayed unchanged or deteriorated in the month. A falling score simply shows businesses are finding things tougher relative to a month earlier; a rising PMI simply means businesses are feeling better.
In November, when shares were falling out of favour, Robert Buckland, global strategist at Citigroup (NYSE:C), reminded investors that “every bear market (in shares) starts with a dip but not every dip starts a bear market”.
Buckland maintains a checklist of 18 factors to help investors “distinguish between a sell-off that should be bought and one that should be sold”. In November, only four “red flags” were flying: valuations of US shares were high (although easing back). On average, company balance sheets were a bit stretched from share buybacks and debt-financed acquisitions, profit margins were close to cyclical highs, and the US yield curve had flattened.
With 14 flags looking “less worrying”, his advice was to buy shares during the dip. “Our market targets suggested global equities will end next year 16 per cent higher,” he said. “That suggests an attractive return for those brave enough to buy now. We are not perma-bulls, but it seems too early to call time on this ageing bull market.”
But he concluded: “Trying to squeeze the last returns out of a 10-year bull market (in shares) might not be an appropriate strategy for less agile investors. The late-cycle combination of lower returns and higher volatility might make it more appropriate for them to head gradually towards safer assets such as cash and government bonds. This accumulates the firepower to buy back into equities towards the bottom of the next bear market. We do think that moment will come, but not until we see more red flags.”
In the outlook for the Chinese economy, too, market sentiment is recently highly negative.
Trend growth in China is certainly moving lower over time: that’s inevitable given the Chinese economy is much larger. There are also signs China’s economy is slowing cyclically.
History shows the Chinese are better at managing the economic cycle than Western strategists generally recognise. High levels of saving and of international reserves help. And there are no opposition parties or democratic elections to thwart necessary moves in policy.
Don Stammer is an adviser to Altius Asset Management and Stanford Brown Financial Advisers.