Wealth Intelligence Weekly 21 Oct 2019
Dimmed but not completely dark
Global economic growth forecasts continue to decline. The International Monetary Fund's (IMF's) latest set of global estimates were released last week, showing that the organisation, based in Washington DC, expects growth of only 3% in 2019. If realised, 2019 growth would be the slowest since 2009. In April it was still expecting 3.2% growth for this year. A year ago, it predicted 2019 growth at 3.7%.
The IMF is not a better or worse forecaster than anyone else - any prediction is inherently difficult (especially when it is about the future, as Niels Bohr famously quipped). Indeed, not long ago in January 2018 then IMF managing director Christine Lagarde, who is now the new European Central Bank (ECB) president, reflected on a "synchronised global growth upsurge" with signs pointing to "a continuous strengthening". However, the IMF is probably the most high-profile forecaster, given its role as guardian of the global financial system. Rather than focusing on the actual point estimate, the direction of change in the forecasts matters. In other words, the fact that successive forecasts are downgraded is notable and reflects the fact that 2019 growth is much weaker than expected.
The IMF blames a broad-based slowdown in industrial activity and lower investment levels for the weaker global growth. Since a lot of investment by firms involves capital goods (machinery), weak investment demand also hits manufacturing. The China- US trade war carries a lot of the blame, with Brexit uncertainty also a factor. Fortunately, the risk of the UK crashing out of the European Union (EU) without an exit deal has considerably reduced. However, the UK Prime Minister failed to get Parliamentary approval for his deal, and has reluctantly requested the EU to postpone the 31 October exit date.
The recent US-China trade truce perked up markets but does not change the underlying fundamental picture. Tariffs implemented over the past year remain in place, and companies will still operate in an environment of great uncertainty, knowing that President Trump can tweet a new set of tariffs the second China does something that irks him. In fact, his Treasury Secretary, Steve Mnuchin, warned soon after the trade agreement that tariff increases were still on the cards for December if ongoing talks don't proceed well. Therefore, it is extremely difficult for firms to plan ahead. The fear is that they become increasingly reluctant to make hiring and investment decisions until clarity improves.
So why given all this gloom are equity markets so strong? The MSCI All Country World Index is still up 18% this year in US dollars. As it is often said, markets are forward-looking, and are anticipating an improvement. In other words, they are not expecting the slowdown to degenerate into a full-blown recession. Indeed, the IMF expects global growth to improve to 3.4% next year. Analysts' earnings estimates are adjusted on a daily basis, and these already reflect the current slowdown and the expected improvement. For the MSCI All Country World Index, Refinitiv data show consensus earnings per share growth of 1.4% for 2019. (In January, analysts still expected 8% growth this year.) 2020 growth is expected to bounce back to 10%. Therefore, the forward price:earnings ratio at 14.9 is still in line with its long-term average. Within this global index, one should separate US and non-US, with the former being relatively expensive, as a result of outperforming the latter over the past five years. In total, equity markets are priced to deliver average growth. The yield on equities still handsomely exceeds the yield on bonds for most major markets.
The key assumption is that the weakness in the manufacturing and trade sectors does not spill over into services and consumption. In simple terms, the part of the economy that produces and moves physical things is under pressure, both because of overproduction of some items (cars in particular) and because of tariff uncertainty. However, the part of the economy that consumes those goods, as well as services, is still humming along. In developed countries, consumers spend more on services (healthcare, housing, banking, internet, travel, grooming etc) than on goods (food, furniture, appliances, cars, smartphones etc). In the case of the US, 70% of consumer spending is on services and 30% on goods.
In major developed economies, consumer spending is well supported by low interest rates, low inflation and low unemployment. The risk is that struggling producers start laying off large numbers of workers. Those workers are also consumers. And if your neighbour is a factory worker and loses their job, you might decide to spend less and save more, just in case, even if your job is still safe. That is how the weakness in manufacturing can spill over into services, but there is little evidence of it happening, and manufacturing employment is relatively small to begin with (only 13% in the case of the US).
So, if the world economy hinges on consumption spending, what is the state of the consumer? Firstly, the US consumer is king. In fact, the dollar amount of annual US household consumption spending exceeds total economic activity in China. US retail sales missed expectations in September, but was still 4% higher than a year ago (depending on your choice of basket). This number is consistent with reasonably solid growth in the US economy, but certainly things are less buoyant than in 2018.
Chinese retail sales increased to 7.8% year-on-year in September, but growth has steadily declined from the low double digits three years ago. Overall Chinese economic growth slowed to 6% year-on-year in the third quarter, the slowest rate since 1990. For Chinese policymakers the distinction between the industrial and services economies is not just a cyclical question but a structural one. They want China to become more reliant on internal consumer demand and less on producing and exporting things. Even as overall growth is slowing, evidence shows that this ‘rebalancing' is taking place. While Beijing wants to prevent a sharp slowdown, it is reluctant to pull out the old playbook of flooding the economy with credit, since debt levels are already high and spread into poorly regulated sectors of the financial system. Nonetheless, more stimulus is expected.
In South Africa, we all know the consumer is squeezed. Even though inflation has declined materially in recent years, interest rates are high, income growth has slowed and the tax burden has increased. Stats SA's retail sales report gives a good indication of the health of consumer spending. Retail sales only grew by 4% in nominal terms in the 12 months to August and 1% in real terms (after inflation). Retail inflation was therefore 3%, which though a bit higher than recent months, is below overall consumer inflation.
Locally, the services sector is also performing better than the industrial sector. Apart from more recent global headwinds, local manufacturers also had to contend with electricity supply disruptions. The return of load-shedding is yet another blow. The impact on the economy will depend on how long it lasts, but the negative impact on sentiment is immediate. With production stumbling and consumption under pressure, it is no wonder that the IMF is forecasting only 0.6% growth in 2019 and 1.1% growth next year. The weak growth outlook continues to weigh on local asset prices. The lack of a turnaround story - which the latest loadshedding underscores - means investors are prepared to pay less and less for each rand's worth of earnings generated by JSE-listed companies. In other words, the market has become a lot cheaper, with the forward price:earnings ratio back at levels last seen in 2012.
For local investors, the dilemma is that the yield on bonds is even higher, while the earnings outlook is uncertain. The slow economy puts pressure on government finances, resulting in rising debt levels, which in turn means that investors demand a higher yield for buying local government bonds. Importantly, there is still no shortage of buyers, but the government has to sell these bonds at a discount compared to other emerging markets.
In summary, the world economy is clearly fragile, but should hold up with the help of considerable monetary easing. A modest improvement next year seems probable. A strong rebound would require fiscal stimulus, which governments can afford with record-low borrowing costs. In South Africa, we are not so lucky. There is no prospect of fiscal stimulus, little hope of aggressive interest rate cuts, and we remain hobbled by supply-side interruptions. The economy will have to recover on its own steam and this will take time. But local bond and equity valuations already reflect this unfortunate situation, and should not be dumped at current low prices. All the above still argues for a diversified approach to asset allocation instead of taking extreme positions.