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INSIGHTREGIONALASSET ALLOCATION
REGIONAL PORTFOLIOCONSTRUCTION
GLOBAL STRATEGICASSET ALLOCATION
GLOBAL SECURITYSELECTION
HIGHLIGHTED IN THIS PUBLICATION:
QUARTERLY MARKET REVIEW
Q2 2017
OVERVIEW
Steady US expansion continues
UK
Brexit-related uncertainties
EUROPE
Yield curve signals recovery will continue
SPECIAL FOCUS
Small cap growth stock
Tranquil waters?
2 | Insight Q2 2017
*Normal level for NFIB and Consumer Confidence surveys=100; normal level for ISM indicators=50.Source: Thomson Reuters Datastream as at 3 April 2017.
NFIB SmallBusiness Confidence
ISMManufacturing
ISMServices
ConsumerConfidence
-10
-5
0
5
10
15
20
Inde
x p
oint
s
Low point in 2016 pre-election Latest (Jan 2017)
Selected confidence/optimism/business conditions indicators compared to normal level*
US: ‘animal spirits’ are improving… ‘Animal spirits’, the term memorably coined by J M Keynes to describe an improvement in business confidence, have been stirred by the election of President Trump (see Figure 1). The surge in US business optimism is seen, for example, in the ISM survey of manufacturing, which is at its highest level since 2011 (during the sharp economic recovery after the Global Financial Crisis). Although the manufacturing sector is still (and will remain, despite Trump’s protestations to the contrary) a small share of the US economy,1 sentiment in that sector has been closely correlated with overall economic activity in the past: rising ISM survey readings are typically followed by higher overall economic growth. Small business optimism is at its highest level since late 2004, boosted by Trump’s agenda of reducing the regulatory and tax burdens. And consumer confidence has surged: it was last at its current levels during the 2000-2001 ‘dot com’ boom. Of course, the cautionary message from that comparison is that such confidence may not be on firm foundations.
OVERVIEW
financial crisis has typically tended to be weaker than during non-crisis periods. Furthermore, such recoveries tend to be slower and last longer. The current US expansion has now lasted for 93 months. There have been only two other periods of economic expansion longer than the current one (from 1961 to 1969 and from 1991 to 2001).
The duration of the expansion has even led some to consider that a recession may be imminent. We do not see that as likely for two main reasons. First, as US post-crisis growth has been at a slower rate, we think it can continue for longer. Second, outside the US, economic growth is picking up: the eurozone, Japan and the rest of Asia are all seeing improving conditions; and the emerging economies, notably Brazil and Russia, which saw recessions in 2016, are now growing again.
Tranquil – not “revved-up”Having said this, we still see little prospect of the “revved-up” economic growth which Trump, in those exact words, aims to achieve.
A more sedate 2% real GDP growth rate, coupled with a similar rate of inflation, will be enough to allow US companies’ revenues to continue growing at around 4%. That will provide a solid, if unspectacular, basis for continued corporate earnings growth, further helped by any tax cuts which are delivered.
Border adjustment taxOne key aspect of tax reform is the Republican Party’s own plans for a ‘border tax adjustment’ (BTA), which pre-date
Sources: NBER, Thomson Reuters Datastream as at 3 April 2017.
1980 1985 1990 1995 2000 2005 2010 2015-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
%
US GDP % change on yearAverage
Expansions
1year
92months
120months
73months
93months
4.3%
3.6%2.7%
1.8%
…but not flowing through to actual dataIndeed, there is no evidence as yet of a notable rise in consumer spending and economic growth. Indeed, on the contrary, the first quarter of 2017 looks likely to have seen relatively soft gross domestic product (GDP) growth, probably no higher than 2% at an annualised rate. That, of course, is in line with the average growth rate seen since the current US expansion began (see Figure 2).
However, it is a growth rate which we do not think should be regarded as disappointing. Economic growth following a
1. Animal spirits
2. US expansions
Expectations of more reflationary policies around the world have so far run ahead of actual events. Hard data show a relatively tranquil global economy, with reasonable real growth and low inflation.
1 The value added of the US manufacturing sector was 12% of US GDP in 2014, according to the World Bank. See http://data.worldbank.org/indicator/NV.IND.MANF.ZS
Insight Q2 2017 | 3
OVERVIEW
Trump’s nomination as Republican presidential candidate. The currently-favoured plan would impose a tax on all imports of 20% and make US exports tax-exempt. A body of economic theory holds that such a BTA will not affect prices and competitiveness in the country implementing the BTA or abroad because the exchange rate will adjust so as to provide a perfect offset.2 In our view, that assumption is unrealistic: the impact of such a tax on the dollar’s value is, we think, hard to predict; and the US dollar is already quite highly valued relative to fundamental exchange rate assessments.
Under such a border tax system, the greater the proportion of overseas sales, the less tax a company will pay. The higher the proportion of imported costs, the more tax that is paid. So the change, if enacted, will benefit mostly those companies with a large domestic (rather than foreign) cost base and a high proportion of total revenues derived from overseas. We think it will therefore be good for sectors such as transportation and warehousing, manufacturing, and mining; and bad for many service sectors, especially those reliant on using foreign low-costs suppliers.
China’s reflationThere are clear risks to China and Asia from such a US border tax. It could be very negative for Asian supply chains. Domestically, however, the Chinese economy is enjoying its own more reflationary trend. Chinese producer prices have picked up sharply with a large part of this due to supply shortages. Stronger producer prices are normally a good indicator of both nominal GDP growth (see Figure 3) and corporate profits growth.
It may well be that China, not the US, provides the greatest stimulus to global GDP growth in 2017. At market exchange rates China is expected to be the world’s second largest economy in 2017. The IMF forecasts its level of GDP to be US$12.4 trillion, behind the US at US$19.4tr. But because China continues to grow much faster than the US, the growth in its GDP – almost US$1tr – will exceed that of the
US. In that sense, China will add an economy the size of Turkey in just one year. It will contribute more to global growth in 2017 than any other country and, based on the IMF’s forecasts, that will remain the case every year until 2020.
Currencies: long-term trendsCurrency trends have been an important determinant of overall returns in recent years, with exposure to the US financial markets bringing the additional benefit of currency appreciation. With the US dollar now overvalued against a number of currencies, however, relative currency movements may well take on more importance. Although currencies tend to be very volatile on a short-term basis, long-term trends can be powerful.
A country such as Switzerland, with persistently low inflation and a large current account surplus, has seen its currency steadily appreciate against the US dollar over time (see Figure 4). Quite the opposite fundamentals, and quite the opposite trend, have been seen for the pound sterling.
The Swiss franc has appreciated over time so that one Swiss franc now buys around one US dollar; sterling has depreciated over time and may well approach a 1:1 milestone against the dollar, especially if the process of extrication from the EU proves difficult.
Source: Thomson Reuters Datastream as at 3 April 2017.
02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17-12
-8
-4
0
4
8
12
16
%
0
4
8
12
16
20
24
28
%
Producer prices, % change on yearNominal GDP, % change on year (rh axis)
Source: Thomson Reuters Datastream as at 3 April 2017.
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 20150.00
0.50
1.00
1.50
2.00
2.50
3.00
1 Swiss franc 1 Pound sterlingNumber of US dollars bought with:
USD
per C
HF &
GBP
BrettonWoodssystem
Plaza Accord22 September 1985
3. China: PPI and GDP
4. Swiss franc and pound sterling
2 See Auerbach and Holtz-Eakin, The Role of Border Adjustments in International Taxation, American Action Forum, 2 December 2016. https://www.americanactionforum.org/research/14344/
We return to these themes after a discussion of recent asset market performance.
4 | Insight Q2 2017
Asset market performanceOver the course of the first quarter of 2017, the US dollar weakened against other major world currencies. The declines were relatively modest against the euro, sterling and Swiss franc, but more notable against the yen, with that currency appreciating by almost 5% against the dollar in the period.
The weakening of the US dollar meant that the 5.8% local currency return from the MSCI World equity index rose to 6.9% when expressed in US dollar terms. Overall world equity market returns exceeded world government bond market returns. The phenomenon was seen across all the main regions and countries (see Figure 5).
Bond marketsThe rise in US government bond yields seen in late 2016 did not continue through into early 2017: the ten-year government bond yield at the end of the first quarter was little changed on its end-2016 level. In the eurozone, the general trend was for yields to rise, from what had been low levels at the end of 2016. German 10-year yields, most notably, rose from 0.11% to 0.33% over the period. One concern was that the ECB may cut back on its bond purchases earlier than previously anticipated, not least because inflation moved up to 2% in February. The rise in yields meant that, in euro terms, there were modest losses from eurozone bonds in the period although the strength of the euro against the US dollar transformed that into a modest positive gain in US dollar terms (see Figure 6).
The UK gilt market produced the strongest returns in local currency terms, as ten-year gilt yields dropped to little more than 1.0%. The strongest gains in US dollar terms were in the Australian dollar bond market, where local currency gains
were accompanied by a strong gain in the currency: that was helped, in particular, by firmer commodity prices, which tend to benefit the Australian currency.
Equity marketsAsian equity markets produced some of the strongest returns in the first quarter of the year (see Figure 7). Signs of improved export growth helped South Korea, Taiwan and China; and the Indian market recovered as the adverse impact on the economy of last year’s withdrawal of large denomination banknotes started to fade.
Returns from the major developed markets – the UK, US, Japan and Germany – were in the range of 5.5%-8.5% in US dollar terms in the period. The Russian market was one of the weakest in both local currency and US dollar terms as hope of relief from sanctions faded and the oil price did not sustain higher levels.
ASSET MARKET PERFORMANCE
The prospect of more reflationary global policies and improved business and consumer sentiment helped global equities outperform bonds in the first quarter of the year.
Source: Citigroup (bonds); MSCI (equities). Data for three months to end-March 2017.
US Europe Japan Emerging World-2
0
2
4
6
8
10
12
14
%
Equities, total returns, US dollar terms
Bonds, total returns, US dollar terms
Source: Citigroup. Data for three months to end-March 2017.
Eurozone US Canada Switz. NewZealand
UK Japan Australia-2
0
2
4
6
8
%
Local currency termsUS dollar terms
Source: MSCI. Data for three months to end-March 2017.
RussiaUK
JapanItaly
USGermany
SwitzerlandBrazil
ChinaSpain
IndiaSouth Korea
-10
-5
0
5
10
15
20
%
Local currency terms US dollar terms
6. Bond market returns
7. Equity market returns
5. Asset market performance
Insight Q2 2017 | 5
UNITED STATES
Government finances are often considered a very complex subject. But the simple reality for the US is that tax cuts accompanied by no change in government spending will lead to an increase in public sector debt.
Long-term US fiscal trendsThe general trends in US public finances are relatively straightforward. Government revenues have centred around 18% of GDP for decades (see Figure 8). In the absence of any change in tax policy under President Trump the non-partisan Congressional Budget Office expects these to stay at the same level for the next 10 years.
Given that federal debt would have risen even in the absence of Trump’s policies, this implies an increase to US$24tr, 98% of GDP, by 2024 (see Figure 9) with his policies.
Sources: US Congressional Budget Office, The Budget and Economic Outlook: 2017 to 2027 (January 2017) and Committee for a Responsible Federal Budget Promises and Price Tags: A preliminary Update, 22 September 2016.
1965 1975 1985 1995 2005 2015 2025141516171819202122232425
% o
f GDP
RevenuesRevenues post-Trump election
OutlaysOutlays post-Trump election
8. US government finances
Similarly, the path of government spending is quite predictable. In the absence of any changes by President Trump, this is expected to rise in the coming 10 years (see Figure 8). 93% of the rise in spending is accounted for by entitlement spending, which is determined under current law: it is a path which is essentially “baked in”.3
Less tax revenue, little change in spending…Treasury Secretary Mnuchin initially planned to pass a “very significant” tax reform plan by August (but now more likely in the Autumn). On spending, President Trump plans an annual increase of US$54bn for defence, as well as more for homeland security – these being financed by cuts elsewhere. Trump’s healthcare reforms would have provided an offset, as they were estimated to reduce the federal deficit by US$337bn over the ten years 2017-2026, but those reforms have now been dropped. Although produced before Trump’s election, the projections from the Committee for a Responsible Federal Budget still provide a reasonable guide to Trump’s intentions. Broadly, the plans amount, over ten years, to: tax cuts of US$5.8tr; US$1.2tr of primary (i.e. non-interest) spending cuts and an increase in interest costs of US$0.7tr. The net effect is an increase in the federal deficit of US$5.3tr over 10 years.
Sources: US Congressional Budget Office (CBO), January 2017 (‘pre-Trump election’ projections) and Committeefor a Responsible Federal Budget, October 2016 (‘post-Trump election’ projections) available at:http://crfb.org/sites/default/files/Promises_and_Price_Tags_Preliminary_Update.pdf
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 20240
5
10
15
20
25
30
USD
trill
ion
Debt USD trillion, pre-Trump election Debt USD trillion, post-Trump election
2008: US$5.8tr39% of GDP
2016: US$14.2tr77% of GDP
2024: US$24.3tr98% of GDP
9. US government debt
There are important caveats to these projections: uncertainty as to which policies will actually be implemented; whether or not stronger US economic growth can indeed be generated and how much extra tax revenue it would produce; and, finally, prospects for the global economy, which has shown encouraging signs of strength recently, but which would be vulnerable to any dislocation from a marked change in US trade policy.
…means more debtIs there a concern about the US debt level reaching almost 100% of GDP? Certainly, Trump himself has criticised the ‘doubling of the debt’ which took place under Obama. The work of Reinhart and Rogoff showed that government debt levels above 90% were associated with much weaker economic growth..4 Although the size of the effect they found has been challenged, a link does still exist.
Trump does not appear overly concerned by an increase in federal debt, claiming that he would “borrow knowing that if the economy crashed, you could make a deal.”
Plans for a US$1tr infrastructure programme, with US$167bn financed by the government and the rest by the private sector, would be an additional source of borrowing but plans for that scheme now look unlikely to be announced until 2018.5
Of the many uncertainties surrounding the outlook for US policy, those of a fiscal nature will dominate 2017.
3 In the words of Kim Wallace, RenMac, speaker at the EFGAM Knowledge Exchange, January 2017.4 Reinhart and Rogoff, ‘Growth in a Time of Debt’, American Economic Review (2010).5 Wilbur Ross and Peter Navarro, ‘Trump Versus Clinton On Infrastructure’, 27 October 2016.
6 | Insight Q2 2017
UNITED KINGDOM
The prospect of two years of uncertainty, as the UK negotiates its terms of withdrawal from the EU, is a source of vulnerability. For now, however, markets have remained calm.
Brexit uncertaintiesTwo years of uncertainty lie ahead for the UK, as it seeks to agree its terms of withdrawal from the EU. Quite how that process evolves is very difficult to know, but both parties to the negotiation seem willing to conduct talks in a spirit of co-operation.
UK economy holding upFor the time being, UK economic growth has held up well. Projections of a sharp fall in output in the event of Brexit have, at least for now, proved groundless. The Bank of England, notably, now sees UK GDP growth running at 2% in 2017 (above consensus forecasts). We are concerned, however, that UK growth and, with it, the value of sterling, remain vulnerable.
Sterling vulnerabilityThe weakness in sterling seen since the June 2016 referendum decision is already impacting the UK economy. Higher imported goods prices have pushed up consumer price inflation to 2.3%, the same as the rate of nominal wage increases. Real wages, therefore, which were showing a strong increase for much of 2016, are now not growing (see Figure 10). That is expected to put downward pressure on UK consumer spending, especially as household debt levels remain high and savings have recently been run down. As consumer spending remains the main contributor to overall GDP growth, the vulnerability of growth is clear.
It is likely that sterling will remain under pressure during the Brexit negotiations, not least because the UK still has a sizable current account deficit – close to the size (relative to GDP) which has been associated with currency crises in other countries in the past (see Figure 11). That means that
Source: Thomson Reuters Datastream as at 3 April 2017.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017-3-2-101234567
% c
hang
e on
yea
r
Total wages, 3-month moving averageCPI inflation
Source: Economist Poll of forecasters, 11 March 2017. Data for Mexico, Thailand, Spain, Portugal, Greece,Estonia and Iceland refer to their ‘crisis years’.
-2.6 -2.8 -3.4 -3.4 -3.6 -4.4-6.2 -7.2 -8.1 -8.8
-12.2-14.4 -15.0
-24.8
US Turkey UK Mexico(1994)
Spain(2007)
Greece(2008)
Mexico SouthAfrica
Colombia Egypt Thailand(1996)
Portugal(2008)
Estonia(2007)
Iceland(2008)
-30
-25
-20
-15
-10
-5
0
Defi
cit a
s %
of G
DP
Current account deficit as % of GDP, 2017 Previous crises
10. UK real wage squeeze
the UK has to attract a foreign capital inflow to finance the deficit: in the words of Mark Carney, it is reliant on the “kindness of strangers”.6
For the time being, that is not proving to be a problem: UK 10-year government bond yields fell during the first quarter of the year to just over 1%, whereas yields on eurozone government bonds rose over the same period; the equity market has remained relatively stable; and anecdotal evidence of inward investment flows suggests that this has not been impaired.
Looking for a ‘Bafta’Sterling’s weakness does have some beneficial effects, of course: the income from assets overseas and profits earned by UK companies abroad become more valuable in sterling terms; and the UK’s export price competitiveness is improved. After leaving the EU, the UK will be free to agree its own trade deals with the rest of the world. UK negotiators are apparently seeking a ‘Bafta’ – a Big Ambitious Free Trade Agreement – involving closer trade ties with the US; the 51 other Commonwealth countries, a group which includes some of the largest and fastest-growing emerging economies in the world (India, Nigeria and South Africa) as well as former colonies and dependencies which are now advanced economies (Australia, Canada and Singapore). As long as the UK is a member of the EU, trade with such economies is subject to the common external tariff, as well as other non-tariff barriers, imposed by the EU.
While that means there may be much to gain after EU withdrawal, a difficult negotiating period lies ahead.
11. UK current account deficit
6 “Mark Carney fears Brexit would leave UK relying on ‘kindness of strangers’ ”, The Guardian, 26 January 2016.
Insight Q2 2017 | 7
EUROPE
Improved business confidence is being seen in Europe as well as the US, but the recovery varies markedly between countries. Political concerns are subsiding and inflation is back on track.
Recovery in confidenceA revival of business confidence is being seen in Europe as well as the US. The German IFO business climate index, for example, showed its strongest reading in March 2017 since 2011 (before the onset of the eurozone crisis). Nevertheless, the recovery remains uneven, with Italy, in particular, showing little growth (see Figure 12).
Source: Thomson Reuters Datastream as at 3 April 2017.
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 201790
92
94
96
98
100
102
104
106
108
GDP
Inde
x, pr
e-cr
isis
pea
k =
100
GermanyFrance
ItalySpain
Source: Bloomberg as at 3 April 2017.
3m 9m 2y 4y 6y 8y 10y 12y 14y 16y 18y 20y 22y 24y 26y 28y-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
%31 December 2015
30 June 2016
Maturity (months/years)
30 December 201624 March 2017
12. Eurozone: an uneven recovery
13. Eurozone yield curve
Bavaria) led by Angela Merkel. While the AfD (Alternative für Deutschland) continues to attract support, it seems highly unlikely it will have a role in any new coalition government.
Inflation back on trackEurozone inflation is back on track. At 1.98% in February 2017, it is exactly in line with the ECB’s target of “less than but close to 2%”. It had been below that target since mid-2013, leading some to fear that the eurozone may become stuck in a Japanese-style deflationary trap. Those fears have now receded and expectations have turned towards the ECB’s quantitative easing being phased out earlier than many expected and policy interest rates starting to rise. The message from the increasingly upward sloping yield curve (see Figure 13) is that a recovery in growth and higher interest rates are expected.
Foreign inflowsAttitudes towards Europe on the part of foreign investors also seem to have turned more optimistic, admittedly from very weak levels. Late March 2017 saw the strongest inflows into European equity funds for more than a year, after relentless outflows for most of 2016,7 signalling in part reduced concerns about the European political situation.
Easing political concernsAlthough Brexit and Trump’s victory suggest extreme caution in predicting election results, it seems increasingly unlikely that Marine Le Pen will be successful in her bid to become the next French president. Polls show a lead for Emmanuel Macron, helped by scandal surrounding François Fillon, the Republican party candidate. While Le Pen may well progress from the first round of voting (on 23 April) to the second round (on 7 May), her support base of 8-9 million voters is unlikely to expand by the required 7 million votes needed for her to secure victory in the second round.
In Germany, a federal government election will be held on 24 September. The SPD is seeing increased support under the new leadership of Martin Schulz, former President of the European Parliament. That party currently forms a Grand Coalition with the CDU/CSU grouping (Christian Democratic Union of Germany/Christian Social Union in
Search for yieldThe ECB’s negative deposit rate of 0.4% has proved widely unpopular and even German finance minister Schäuble has voiced criticism. Such low rates encourage the search for alternative investments but German 10-year bond yields at just 30-40 basis points offer only a limited yield advantage.
If political uncertainties continue to recede as expected, the European equity market may look increasingly attractive.
It is fundamentally cheap compared to other equity markets around the world; it offers a much higher dividend yield compared to the yield on government bonds; and, an often-overlooked issue, European companies may well start to emulate US companies and start buying back their equities in a more enthusiastic fashion. As in the US, this may well be encouraged by particularly low borrowing costs.
7 Source: EPFR Global data to 29 March 2017.
8 | Insight Q2 2017
JAPAN
Sources: Bank of Japan, Thomson Reuters Datastream as at 3 April 2017.
2010 2011 2012 2013 2014 2015 2016 2017-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
%
CPI inflation rate (‘Headline’)CPI less fresh food inflation rate (‘Core’)CPI underlying inflation rate, excl. food, energy and impact of VAT rise (‘Core-core’)
2% Target
INFLATIONDEFLATION
Sources: Bank of Japan, Thomson Reuters Datastream as at 3 April 2017.
Headline Core-coreCore-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
%
3.743.40
2.42
-1.70
-2.52
0.11
-2.40
-0.10 -0.10
Average inflation since 1994Maximum Minimum Average
Sources: Thomson Reuters Datastream and JBRC (http://jbrc.recruitjobs.co.jp/data/index.html)
2012 2013 2014 2015 2016 2017-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
% c
hang
e on
yea
r
Full-time monthly wagesPart-time hourly wages
14. Japan: edging away from deflation
15. Long-term inflation trends
16. Japan: wage trends
Japan’s central bank looks likely to maintain its easy policies in a more determined attempt to raise inflation and growth. After more than two decades deflation may be conquered.
8 Krishna Guha, Evercore ISI, at the EFGAM Knowledge Exchange, January 2017.
Finally getting there?Since the mid-1990s Japan has been unable to shake off deflationary pressures, but there is now greater optimism that new measures introduced in September 2016 will start to work. The main technique now favoured is a cap on 10-year government bond yields at 0%. The hope is that this will provide a positive feedback loop: bond buying by the Bank of Japan (BoJ) is accelerated as bond yields rise, thereby expanding the BoJ’s balance sheet and increasing banks’ liquidity.
Headline, ‘core’ and ‘core-core’ inflationThe headline inflation rate (see Figure 14) has moved into positive territory but the BoJ’s two other measures of inflation – ‘core’ inflation (excluding fresh food prices) and ‘core-core’ inflation (excluding food, energy and the impact of the 2014 increase in VAT) are both still close to zero. The longer-term trend on the basis of these three measures, since general deflation took hold in 1994, is shown in Figure 15.
Why now?Why might stimulative policy work now in generating higher inflation and growth when it has failed in the past?
First, there seems to be a growing determination to maintain easy policies until they have worked. Krishna Guha comments that it is now accepted by the Bank of Japan that it needs to “dig in for a longer game”.8 However, a key element of the transmission mechanism from that policy to higher inflation is via a weaker exchange rate. And, as is so often the case in Japan, the trend in the exchange rate has defied conventional expectations by appreciating, rather than weakening, against the US dollar in the first part of 2017.
Second, there is evidence of upward pressure on wages, notably for part-time hourly paid workers (see Figure 16). Companies tend to find it easier to raise part-time wages in response to economic conditions since they can quickly reverse course in a downturn, whereas the wages of full-time staff – especially in Japan, where lifetime employment remains prevalent at large companies – are harder to cut.
Third, that wage pressure reflects skill shortages in key sectors of the economy, notably construction, which may well intensify as Japan prepares for the 2020 Olympics. Spending ahead of that can add 0.2 to 0.3% to growth, in our view, allowing Japan to register overall GDP growth above 1% in 2017 (for the first time since 2013).
On balance, Japan now stands a better chance than for many years of shaking off its deflationary problems.
Insight Q2 2017 | 9
ASIA
Source: Thomson Reuters Datastream as at 3 April 2017.
% c
hang
e on
yea
r, US
D te
rms
Taiwan Korea
2011 2012 2013 2014 2015 2016 2017-20
-10
0
10
20
30
40
Source: National Bureau of Statistics China as at 3 April 2017.
2009 2010 2011 2012 2013 2014 2015 2016 2017F-6
-4
-2
0
2
4
6
8
10
12
14
%
Final consumption expendituresGross capital formation
Net exports of goods & servicesReal GDP
17. Asian exports
18. China: contributions to GDP growth
At the start of the year Asian prospects were overshadowed by President Trump’s trade rhetoric. Underlying conditions in Asia, however, have picked up. China is now set to be the biggest contributor to global growth.
Trade recoveryAsia is still a very export-dependent region and in that respect conditions have improved quite markedly. Exports from Taiwan and South Korea, the two economies which report their trade data earliest, show a sharp upturn early in the first three months of the year (see Figure 17).
Capital formation (and destruction)Beneath the surface, however, important changes are taking place. 2016 was the first year of China’s new 5-year plan, which has a focus on infrastructure spending, an important component of fixed capital formation. 34 more cities are now able to construct a subway system, after the threshold qualifying population was halved (in that plan) to 1.5 million inhabitants. At the same time, China’s investment boom over the last three decades has created widespread excess capacity in heavy industries (such as coal, steel and cement) which the government is now addressing. Capacity is being cut and job losses are inevitable. Meanwhile, a key focus of China’s long-run growth prospects is spending US$1tr on infrastructure in its ‘One Belt, One Road’ plan. This links China to as many as 65 countries in Asia, Europe and Africa. The plan is to open up new markets for Chinese production.
Consumer spendingConsumer spending in China has continued to grow in a relatively stable manner, at around 10% year-on-year in nominal terms. The trend is supported by state-mandated minimum wage increases and pent-up demand for many consumer goods and services. Chinese consumers accounted for 30% of the worldwide market for luxury goods in 2016.9
Despite threats from US policy, we see China continuing to contribute strongly to global growth in 2017 and thereafter.
That has come, ironically, as the region has been overshadowed by the uncertainty surrounding the direction of policy under President Trump. His election pledges to impose punitive tariffs on China and to label the country a ‘currency manipulator’ have, so far, not materialised.
The issue of tariffs on China has been deflected by the proposals for a general US border tax with all countries and any issue of alleged currency manipulation is in the domain of the US Treasury, which will report in April 2017. It uses three tests: whether a country has a trade surplus with the US of more than US$20bn per year (China does); whether the economy has an overall current account surplus with all countries above 3% of GDP (China does not); and whether the country buys foreign currency amounting to more than 2% of GDP (China does not – it is now running down, not accumulating, foreign currency reserves).
China’s (predictable) economyWhile exports help drive growth across Asia, China itself is also a large importer. Net trade (exports minus imports) has made little contribution to overall GDP growth in recent years (see Figure 18). Rather, just over half of GDP growth in 2016 came from fixed capital formation; and just under a half from consumer spending, continuing a pattern seen in each of five preceding years. 2017 is expected to be little different.
9 Bain & Co, Luxury Goods Worldwide Market Study, Fall-Winter 2016, 28 December 2016.
10 | Insight Q2 2017
LATIN AMERICA
Source: Thomson Reuters Datastream as at 3 April 2017.
Jan Feb Mar Apr AprMay Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar
16
17
18
19
20
21
22
23
US dollar : Mexican peso Trump election victory
2016 2017
Weakerpeso
USD:
MXN
Source: Thomson Reuters Datastream as at 3 April 2017.
2000 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 170
5
10
15
20
25
30
%
Brazil’s official interest rateConsumer price inflation rate
Sources: Thomson Reuters Datastream as at 3 April 2017.
Mexico(IPC)
Brazil(Bovespa)
Chile(IGPA)
Argentina(Merval)
Venezuela(IBC)
0
5
10
15
20
25
30
35
40
%
Stock market % change, 31 December 2016 to 31 March 2017
19. Mexican peso pre- and post-Trump‘s election
20. Brazil: interest rates and inflation
21. Stock market performance
Mexico remains in the spotlight as far as the impact of President Trump’s measures are concerned. But important developments are taking place elsewhere, from Argentina to Venezuela.
Mexico, Trump and RossMexico remains a key focus not just for Latin America, but for the entire global economy. Its supposedly unfair trade practices and the need to build a wall with it were keynote aspects of President Trump’s election campaign.
Attitudes have, however, changed quickly, demonstrated by the recent strong appreciation of the Mexican peso against the US dollar (see Figure 19), from what was a clearly oversold position in the immediate aftermath of Trump’s election.
Figure 20). While the weak economy and declining inflation give scope for rates to fall much further, the central bank is determined to burnish its counter-inflation credentials.
From Venezuela to ArgentinaThe threat of high inflation, indeed hyperinflation, remains a ‘clear and present danger’ in Latin America. In local currency terms, the Venezuelan stock market has produced the highest returns so far in 2017 (see Figure 21). But those gains are illusory. Rampant inflation, bordering on hyperinflation, and a consequently depreciating currency far outweigh any notional gains. Meanwhile, Argentina, no stranger to very high inflation itself, continues to make good progress with economic reform and the equity market gains which have reflected this are more firmly based.
Self helpIndeed, some see the new administration’s policies as potentially strengthening US-Mexico trade links. Wilbur Ross, US Commerce Secretary, has suggested, for example, that the US could work with Mexico to stabilise its currency (as happened in 1994’s ‘Tequila crisis’). It could also be the case that any renegotiation of the North American Free Trade Agreement (NAFTA) strengthens, rather than weakens, the Mexican economy. Such a renegotiation could improve protection of intellectual property rights, putting Mexico’s trading relationship on a firmer, developed world basis. It could also lead to better labour market practices, with better protection for workers’ rights.
There has, importantly, been an element of ‘self help’ in the currency’s stabilisation. Banxico, as the central bank is colloquially known, has delivered six half-point increases in its policy interest rate over a year, taking the rate to 6.5%.
BrazilBrazil is in a different position. The central bank has cut rates from 14.15% to 12.15% over the last six months (see
Insight Q2 2017 | 11
SPECIAL FOCUS – US SMALL CAP GROWTH STOCKS
Source: Thomson Reuters Datastream as at 3 April 2017.
1990 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16-40
-20
0
20
40
60
Tota
l ret
urn
in y
ear (
%)
Small cap growth stocks (Russell 2000 Growth Index)Large cap, all stocks (S&P 500 Index)
Source: World Bank as at 3 April 2017.
1980 1985 1990 1995 2000 2005 2010 20150
1000
2000
3000
4000
5000
6000
7000
8000
9000
Number of domestic US-listed companies
22. Small cap growth versus large cap stocks
23. US: listed companies in decline
US small cap growth stocks are, we think, a particularly attractive area of the US equity market at the moment. Such stocks have tended to be neglected in recent years.
Small cap growth stocksHistorically, US small cap growth stocks have delivered stronger returns than large cap stocks in some years, but the performance has been volatile: in the last few years the sector has underperformed the large cap market (see Figure 22). The returns from initial investors in such small cap growth stocks have, in the past, been very attractive. Apple, Microsoft and Amazon were all ‘small cap’ stocks (that is, with a market value of less than US$2bn) at their IPOs.
De-equitisationPublic listings have, however, become less popular for US companies. The US equity market is becoming “de-equitised.” The number of domestic US-listed companies has declined from its peak in the mid-1990s (when over 8000 such companies were listed) to little more than half that number currently (see Figure 23).
Tech sector The technology industry provides a good example of that trend. In that sector, the private fundraising market now dwarfs its public counterpart. There were just 26 technology IPOs in the US in 2016, raising $4.3 billion; meanwhile, US tech companies raised $19 billion in the private equity market (see Figure 24).
Sources: Dealogic and Dow Jones VentureSource as at 3 April 2017.
IPOs(Initial Public Offerings)
PE(Private Equity)
0
2
4
6
8
10
12
14
16
18
20
USD
billi
on
Amount raised in 2016
US$4.3bn
US$19.0bn
809
26
Number of times accessed
24. US tech sector funding
Advantages of being privateIn the technology sector, and more broadly, many small cap growth companies tend to favour private equity channels for a number of reasons. These include less onerous reporting requirements; the desire to keep a lower public profile; a reduced emphasis on maintaining and improving quarterly earnings; and a greater flexibility to spend on, for example, research and development which may harm earnings in the short-term but have a long-term benefit.
At the same time, inflows into private equity funds have been strong, meaning that, in the language of the industry, there is a large amount of ‘dry powder’ – money committed by investors, but not yet invested. This surplus of investable funds has tended to bid up the value of private small cap growth companies. Meanwhile, the recent underperformance of listed small cap growth stocks has improved their relative valuation compared to the large cap market.
Creative destructionAlthough both private and public financing routes are attractive ways of tapping this vibrant source of US ‘creative destruction’ and future economic growth, public listed markets may well have the edge as a route into the market at this point in time.
12 | Insight Q2 2017
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