Tatton's 2018 Outlook
22 December 2017
As we move into 2018, the ‘end of the cycle’ has become the dominant topic for the investment community. After 10 years of both markets and the real economy trending upwards (though only recently has the economy been strong), some fear that things will head the other way soon. However, our central case for next year is that the global economy will continue to move forward, even though capital markets may be entering some choppy waters.
Let’s start with a recap. Investment returns were overwhelmingly positive over 2017, as markets shook off worries at the beginning of the year to end near or on record highs. Despite global central bank policy starting to become less easy, the spare liquidity available to investors (termed “financial conditions”) increased sharply and sloshed towards assets - equities in particular - producing very healthy returns with historically low volatility.
This boom in the financial economy has been backed up by solid real economic growth., and we end 2017 at a very strong level. Goldman Sachs’ December estimate for current global growth is 3.7%, the strongest since 2006. Employment rose and confidence generally went up. In this strong picture, the surprise was that inflation stayed low, apart from the UK. That’s one reason why the UK performance lagged the rest.
Everything going so smoothly has led many to suspect it’s the calm before the storm. This is understandable; post-war economic cycle lengths have averaged about six years while investment returns have tended to see flat-to-bad years follow a couple of good and vice versa. But cycles don’t die of old age. Without some dynamic causing a downward shift, it’s reasonable to expect that the global economy will continue to move forward even as the current cycle enters its tenth year. So, what could bring the party to an end?
In our view, the two factors that could cause a slowdown in 2018 are a fall in consumer confidence and the continued effects of quantitative tightening (QT). If the former happens, it is likely to be in those regions where wage growth is low, consumers have already expanded their debt and - such as in the US and the UK - traditional businesses face yet more pressure from tech-based competition.
The rise in employment this year has brought a large number of people’s spending power up. But as we hit “full” employment, the rate of employee growth slows. At this stage, one would expect wages to rise more quickly. But so far, in most regions, it hasn’t happened to any extent. In our discussions with many analysts, we would characterise the consensus view on wage growth acceleration as “it hasn’t yet happened but it will”. We disagree with this view, and think that, if it was going to happen, it should have happened already. Structural issues in certain economies (Brexit in the UK and labour market issues in the US, which we’ll cover more later) are the main constraint.
If employee growth slows and wage growth remains slow, continued consumption growth relies on debt growth. In the US and the UK, savings rates have already been coming down considerably and its unlikely that savings can decline much more. However, we should say here that we don’t expect this effect to be homogenous across the world. Savings rates have fallen in Europe or Japan but remain at levels which leave room for further falls.
Consumer confidence in the US could be bolstered by the effects of President Trump’s tax cut, and UK consumers could well beat the markets’ low expectations, perhaps if Brexit uncertainties continue to clear up. Whatever the case, we’ll likely see a divergence of growth rates across the globe, compared to the very synchronised rates in 2017.
As for QT, we believe this will be one of the dominant macro factors to consider for capital markets next year. The huge amounts of liquidity provided by QE since the financial crisis buoyed assets across all classes and underpinned global activity by keeping the financial system healthy. It’s natural, therefore, that its unwinding might have the reverse effect, particularly in those areas most ‘propped up’ by the incredibly loose financial conditions. Residential property will likely be the prime example of this next year, which we cover in more detail later on. The US Fed has already begun unwinding their asset purchases, and all else being equal they plan to speed this up next year. But, in our view, the more significant factor will be when the ECB and BoJ begin their own QT. The latter two central banks have collectively injected far more money into the global economy than the Fed over the past five years and, even if it’s marginal, their tightening will likely have a bigger impact.
ECB members have already begun “forward guidance” on tightening toward the end of next year. This halting of asset purchases will be priced by markets well in advance. This may mean a tightening of general financial conditions. However, because ECB liquidity has flowed substantially into US assets, it would be as likely to affect the US, where financial conditions have been loosening despite the Fed’s policy moves. We would therefore expect increased bouts of volatility, a distinct change from 2017.
The underlying economy could well keep going strong despite the removal of QE. One of our central predictions for 2018 is that there will be a rotation from capital market growth to real economic growth. The tightness of employment, particularly around skilled labour, and the need to enhance technological assets will drive company capital expenditure. In effect, this would be a reversal of the trend seen since the financial crisis, where booming financial markets raced ahead of lacklustre economic growth.
So, at a general level, we agree with the consensus, that global growth will be positive (although slowing) in 2018 and far from a ‘doom and gloom’ scenario involving a recession. Our “desynchronization” view is probably more pronounced than others, however, and is focussed mainly on potential consumption.
How will the year play out? For the economy, a slowdown is likely to become apparent in the second half of the year - particularly in the US. The consensus view is that the first half of the year will see a continuation of recent momentum, and we’re in line with this. Even so, Christmas consumer spending statistics will be very important for the start of 2018 - again, particularly in the US. If the consensus view of the first six months is correct, we would expect consumer spending to be high, even by seasonal standards. If it’s not, it could well cause market panic that the positive forecasts are wrong.
One last word on cycles. While business cycles don’t die of old age, they tend to be heavily correlated with confidence levels - particularly in investment terms. Towards the end of the cycle, markets become exuberant and tend to approach the ‘overheating’ stage. That is, one can often tell when a crash is about to occur by the fact that everyone becomes massively overconfident. One of the striking things to note this time around, however, is that, despite equities trading at all-time highs with a year of strong synchronised growth behind us, markets appear to lack almost all confidence, with investors extremely worried about valuation levels rather than celebrating them. In our view, this tentativeness makes any sudden crash unlikely. It’s possible that, with growth having moved sluggishly upwards since the financial crisis, when the unwinding of this particular cycle comes it will be similarly sluggish.
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