SlowStrangle

Slow
strangle

Pascal Blackburne & Luc Synaeghel 2017-07-07

However enjoyable the ongoing upward ride in risky asset markets, we confess to becoming increasingly worried about the longer-term outlook. By this we do not mean that we fear a market crash. That, to put it bluntly, would be the better scenario – rapidly aligning valuations with intrinsic company worth and opening a new investment window. No, what we dread is a slow grinding process, whereby risky assets produce poor returns for many years. Alongside slowly rising bond yields, aka negative bond returns, this would be nightmarish for investors.

For now, though, let us relish the shorter-term positive news. Europe is in a particularly sweet spot. Save for the Italian situation, political pitfalls have been successfully avoided, economic growth is accelerating and, absent inflationary pressures, the European Central Bank (ECB) is poised to remain accommodative. European equities are not cheap, but accelerating earnings growth and strong money inflows should propel them higher.

Valuation is even more of a concern in the US and, with the economic cycle further advanced, less earnings upside is to be expected. But, although cautious on US equity market prospects, we do not foresee an economic recession in the near future. The very fact that President Trump is proving slow on the trigger reduces the risk of the US economy overheating this year. In turn, this means that the Federal Reserve (Fed) can continue on its progressive monetary tightening path, rather than risk to kill the cycle with overly aggressive rate hikes.

At the heart of our thought process and economic assessment lies oil. With wage pressures still contained, an oil price upsurge would appear to be the only possible source of a harmful inflation surprise. For now, though, investors continue to ignore the constructive oil supply-demand picture, focussing instead on a string of negative news and reading all oil data in an adverse light. Earlier this year, worries related to the lack of contraction in US inventories. As these proceeded to drop by a massive 300’000 barrels per day between March and June, investor concern shifted to the resurgence in US shale production. That too was unwarranted: much of the additional shale oil is being produced out of “drilled but not completed” wells – heritage of the crisis years. By definition, those wells can only be put to work once. Also, shale growth is occurring alongside a less-discussed decline in US conventional oil production. Presently, market concerns appear to be centred on rising Nigerian and Libyan oil production. But not only is this additional supply limited in absolute terms, the fact that these countries were exempted from the OPEC agreement had to do with their unstable political situation. Their output could thus easily reverse course.

The next shoe to drop in terms of negative oil sentiment could be the ongoing surge in floating storage. Our take is that this has more to do with traders exploiting cheap conditions offered by the depressed tanker market to store oil in anticipation of higher future prices, than with an overproduction situation. Media coverage of this development will not doubt again prove negative but we would urge readers not to capitulate on their oil investments.

The sweet european spot

In just a few months, Europe has gone from a situation where everything could go wrong to one where all lights are flashing green – all except for the sorry Italian case which we discuss in some detail below.

Eurozone economic growth is both accelerating and broadening. Emmanuel Macron’s victory has boosted business confidence across the continent, as well as generated hope that long-needed European Union institutional reforms will finally be tackled. The just commencing UK Brexit talks should take on a softer than expected tone. And even the Italian “zombie” bank issue is now being addressed, with protagonists allowed to circumvent rigid EU rules on grounds that the problem was local (whether that can also be said about Banca Monte dei Paschi di Siena is debatable).

European corporate earnings growth should thus prove strong this year and next, quite possibly beating (even rising) consensus expectations. Not only do profits tend to jump at economic growth inflexion points, but European companies’ net margins are lower than those of their US peers, providing room for catch-up.

Importantly, the ECB is showing no inclination to hit the brakes, even though the usual two preconditions to monetary policy normalisation are now in place: the deflationary peril has been vanquished, according to the ECB President himself, and economic growth is on the rise.

Why then such a wait-and-see attitude? With the transition at the helm of the ECB scheduled for 2019, we believe that Mario Draghi will want to address the Italian government debt issue before passing the baton to his logical successor Jens Weidmann (currently chair of Germany’s Bundesbank and member of the ECB policy committee). With recent bank rescues adding to the burden, Italy’s public debt-to-GDP ratio now stands at a whopping 135%. A possible first step, in the vein of what has been done for Greece, could be for the European rescue fund to buy the Italian debt held by the ECB, then proceed to extend the maturities and lower the rates. Clearly such an operation would need to be achieved before European rates start to ratchet up.

Italian bailout or not, we see it unlikely that the ECB decides on much policy change before the Italian general election, to be held by May 2018 at the latest. A tapering of bond purchases might be announced – but likely alongside a commitment to extend their timeframe further. In any event, we see low odds that European rates be hiked anytime soon.

All told, the combination of supportive monetary policy, accelerating economic and earnings growth, and strong money inflows makes for attractive near-term prospects for European equity markets, notwithstanding valuation concerns. At this point, investors have little choice in our view but to remain exposed.

US update

BCA indflation unemployment

In the much more advanced US economic cycle, issues are naturally quite different. With little slack remaining in the labour market, an overheating of the economy has become a distinct possibility. The consequent unleashing of inflationary pressures would force the Fed to step up its policy tightening – threatening to kill the expansion.

US wage inflation is indeed the “ghost in the bottle”. Despite the unemployment rate having dropped to a 16-year low of 4.3% in June, wages are currently growing at an annual pace of “only” 2.4% – slightly above overall inflation but not yet cause for alarm.

Is there greater slack in the US labour market than the unemployment rate suggests? Has the link between the employment level and wage pressures (the so-called Phillips curve) been broken? We would instead tend to agree with BCA Research that «the Phillips curve becomes “kinked” when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does». That was certainly the experience of the late 1960s (as illustrated in the adjacent chart).

We are confident that the Fed understands this and is keen to avoid letting the wage inflation ghost out of the bottle. Hence its somewhat faster than expected pace of monetary tightening so far this year.

Fortunately, too, President Trump is proving slow on the trigger. Much to his dismay, the implementation of key campaign promises is being delayed by the institutional framework that his administration is having to contend with. Corporate tax reform is a case in point. It now looks to be postponed to sometime in 2018. Which is actually good news: the US economy is really in no need of additional stimulus this year. And the same can be said of the much-touted infrastructure investment program, about which there has been utter silence since the start of the Trump presidential term.