US wages were clearly a prime suspect for a negative inflation surprise – never did we believe in the demise of the Philips Curve. Rather, in our July 2017 investment letter, we alluded to a kinked form of relationship between wages and unemployment, whereby wages become more sensitive to shrinking unemployment as the jobless rate approaches 4%. So here we are, six months down the road, with unemployment having hit a 17-year low of 4.1% and the wage ghost finally coming out of its bottle.
Adding to the inflation risk in the US are the recently announced tax measures, clearly designed to incentivize private investment. Just consider the bullishness radiated by industry captains at the recent World Economic Forum in Davos. And the cherry on the cake will be President Trump’s promised infrastructure spending program, currently the subject of hot debate in the US Congress. Once an infrastructure program has been adopted, the combination of public and private investment should add some 0.7% to US GDP growth, taking it to around 3%.
In essence, the US is about to taste a “challenging” cocktail of cost-push price pressure from rising wages and demand-pull price pressure from faster (investment-led) economic growth. To make matters worse, the country has no currency buffer from firming commodity and energy prices – a trend that should only be reinforced by greater spending on infrastructure.
But inflationary risks are not confined to the US. After years of wage restraint, Germany’s largest trade union, IG Metall has been vying for a 6% pay rise, amid first signs of worker shortage. The two-year agreement just reached, covering some 900’000 industrial employees in the Baden-Württemberg region, involves a 4.3% wage increase, various other payments, as well as the possibility of (temporarily) reducing work week hours from the standard 35 to 28. With IG Metall agreements generally seen as a benchmark for the German industry at large, wage gains are likely to spread to other sectors.
For now, Germany is admittedly somewhat of an exception in Europe. Overall, the Old Continent’s business cycle is far less mature than that of the US. The Eurozone has also been preserved from the inflationary impact of rising commodity prices by the 20% gain in the euro against the greenback over the past year. A buffer which will disappear if, as we continue to expect, the dollar reverses course during 2018. The inflation comeback will then reach Europe too.
Adjusting to a world of rising rates
Stronger economic growth across the globe argues for rising interest rates. In the US more specifically, the three policy rate hikes hinted at by the Federal Reserve (Fed) for 2018 seem very realistic – and could actually prove larger than currently expected.
Bond markets have already begun to adjust. The following table shows 10-year government yields, as of early February, compared to their historical lows as well as their year-end 2017 levels:
Source : Bloomberg
It is interesting to observe the difference in behaviour over the past month between Eurozone core and periphery rates. German yields have moved up, but Italian yields have barely budged and Spanish ones even fallen. While part of the explanation probably lies in the above-mentioned wage/growth parallels between Germany and the US, we would also contend that these divergent paths highlight the influence of the European Central Bank (ECB) on bond markets.
The periphery is where the ECB can still find paper to buy, as part of its continued – albeit at a reduced rate – asset purchase program. With few to no suitable German bonds now available for purchase, the end of quantitative easing (QE) in Europe is approaching, lest the ECB be forced to change its rules. When European QE is indeed terminated, at the latest in the final quarter of this year, beware of rapid spread increases in (highly indebted) peripheral countries.
The silver lining : higher profits
Faster economic growth does not just mean higher interest rates. Fortunately, it normally also translates into higher corporate sales and profits.
For 2018, we expect particularly strong revenue growth for companies across the globe, but also some margin compression due to rising commodity prices, wage pressures in the economies where the cycle is most advanced (again, US and Germany) and still a lack of pricing power. As such, overall earnings progression could actually prove lesser than currently expected by the market consensus.
In any event, earnings growth will not be sufficient to bring market valuations back to attractive levels in historical terms and make investing in equities a clear call. Rather, the stage is set for an ongoing tug of war between the positive profit outlook on the one side, and the negative impact of rising interest rates on the other.
Periodic episodes of market turbulence, such as experienced during the last few days, are thus to be expected. In January investors were solely focussed on the rosy growth outlook for the new year – with tax-related 2017 year-end inflows into pension funds adding to equity market performances. Early February then saw the spectre of inflation emerge, forcing investors to turn their attention back to the (gradually) deteriorating monetary policy environment.
It is difficult to determine at which point the US 10-year yield will reach a tipping point, driving a durable rotation of investors out of equity markets and back into Treasuries. If that level is 4%, then it remains a distant prospect. If 3.5%, then it is within reach – though probably still not a concern for the first half of this year.
To be sure, with shorter term Treasury yields having already overtaken the S&P 500 index dividend yield, the temptation for investors to move back into bonds is increasing, particularly when intending to hold direct positions up to maturity (i.e. not bear the risk of price fluctuation).
For the time being, we remain cautiously optimistic on equity markets: their sweet spot can prevail so long as corporate profits improve, and interest rates do not rise too far, too fast. Beware though of the longer-term outlook. A “slow strangle” scenario, whereby risky assets produce poor returns for many years as interest rates grind higher, continues to be our greatest fear.
A bright outlook for dry bulk shipping companies
In recent weeks, the Baltic Dry Index has undergone a sharp correction, shedding some 35% relative to its mid-December three-year high. But this should come as no surprise: lower freight rates were to expect going into the first quarter of 2018, with Chinese steel production cuts aimed at controlling winter air pollution temporarily lowering imports of iron ore and coal.
Source : Bloomberg
That said, our underlying investment thesis remains very much in place. More broadly, the strong global economic outlook for 2018 will drive 3-3.5% demand growth for bulkers in a year that will see few newbuilds hit the waters (due to the very low level of ship ordering in 2015 and 2016). The pick-up in vessel orders in the second half of 2017 will only impact the fleet from 2019 onwards, to the tune of 3% per annum, at which point scrapping can be expected to accelerate due to the introduction of the IMO ballast and sulphur emission rules. Ship owners will be hesitant to install costly treatment systems on ships that are more than 15 years old, accounting for some 14% of the total fleet.
All told, we expect bulker fleet growth to be limited for the next couple of years, and vessel supply-demand equilibrium to be reached – even turn short – sometime this year. Once the market becomes convinced of this perspective, a second leg up in bulk shipping stocks can commence, assuming of course a stable geopolitical and financial context.