2017 has been an excellent year for investors, with returns outperforming expectations and risk events fizzling out, despite their potential for disruption. The pick-up in global growth, improved global corporate earnings, deleveraging in Europe, and the promise of US fiscal reform have been some of the key drivers of this. In addition, emerging markets have been particularly strong, with Chinese and Indian growth surpassing expectations. Also, a rebound in commodity prices has helped countries like Brazil and Russia, and a weaker US dollar and low rates have aided developing Asia.
In this month’s update we highlight two key dynamics that Australian investors should watch for next year, as they could have a significant impact on both domestic and offshore markets.
The opportunity—a pick-up in global economic growth
Global growth has improved during 2017, with real GDP growth expected to finish at 3.8% according to UBS Global Research (UBS). In 2018, growth is expected to stay in line with this figure, with an improvement in growth expected from India, Brazil and Australia. Stronger economic growth has been a key driver of corporate earnings this year, and this is expected to remain a key driver next year. In terms of the equity market, price/earnings (P/E) expansion from current multiples is expected to be more difficult, so further upside needs to come from earnings growth. That is why the health of the global economy will be a critical focus for investors.
“Stronger economic growth has been a key driver of corporate earnings this year, and this is expected to remain a key driver next year”
There is, however, an upside risk to this estimate, and if growth does exceed expectations, it would be a positive driver for risk assets including equities. The potential upside comes primarily from better-than-expected growth in the Eurozone and China. UBS estimates economic growth in the Eurozone will slow to 1.9% in 2018 from 2.3% this year, and growth in China will slow to 6.4% next year from 6.8% this year. The US could also provide a boost given that a growth rate of 2.2% is expected for both 2017 and 2018. While some tax reform is already included in the forecasts, the expectation is for only moderate reform. As such, any ‘meaningful’ amendments could provide an upside boost to growth.
What does this mean for markets?
All things being equal, if the Eurozone and/or China can maintain their current growth rates, or if the US implements meaningful tax reform, this should benefit corporate earnings. This, in turn, would validate current equity market multiples, which otherwise appear expensive, and it may be a catalyst for higher global equity prices.
In terms of options available for investors, European equities are our favored investment destination over the next six months. The positive outlook is based on:
- A continued economic recovery and metrics like employment continuing to improve;
- Quantitative easing (QE) continuing to provide liquidity despite tapering;
- A rise in government spending as restrictive ‘fiscal austerity’ ends;
- Re-leveraging taking place as business confidence grows after many years of pessimism;
- Corporates growing revenues and this top-line growth feeding through to earnings; and
- A recovery in capital expenditure on a global basis.
From a domestic perspective, Australian equities are also expected to benefit from an improvement in global growth. Australia is generally considered a ‘risk-on’ economy, which flows through to the equity market. Enhanced global growth should benefit demand for natural resource exports, increase tourism and capital flows, and provide the confidence needed to maintain our own leveraged growth—particularly in the housing sector. However, the impact on Australia may be dampened if the Australian dollar strengthens, or if inflation causes offshore yield curves to steepen, forcing the Reserve Bank of Australia (RBA) to raise rates sooner than expected.
“Australian equities are also expected to benefit from an improvement in global growth.”
The threat—inflation rises from the grave
One of the key drivers of rising markets in recent years, whether that’s housing, equities or fixed income, has been the increased liquidity which has resulted from increased debt following the Global Financial Crisis. Given the importance of liquidity for markets, it’s essential to consider any potential threat to it, as it could be a catalyst for markets reversing direction.
Inflation appears to be the greatest threat to liquidity. A spike in inflation would likely see central banks become more hawkish, potentially raising rates faster than currently expected. We have already seen this happen in the UK, where the Bank of England has raised rates in response to inflation reaching 3.0%. We believe the key factors that could cause inflation to rise include:
- Increased demand for goods and services, given the positive outlook on the global economy;
- Increased input costs, such as rising wages;
- Increased import costs from a weaker currency;
- Higher production costs from higher raw material prices; and
- Public sector actions, such as QE and taxation changes.
Most of these potential threats appear to be muted at present, with wage growth particularly slack and showing little sign of rising. In addition to these factors, technological developments are a major deflationary force. This is because they disrupt historical supply chains and distribution channels by generally improving efficiency and driving prices down.
Any major increase in inflation is likely to come from either US fiscal reform, currency appreciation, or a spike in the oil price or broader commodity base.
US tax cuts are likely to be on the softer side
The potential impact of US fiscal reform has been widely discussed. Its eventual impact will depend on the magnitude of any tax cuts, where they are focused and when they are implemented. At present, the plan is to reduce the corporate tax rate from 35% to 20%, which is expected to cost USD 1.5 trillion over the next 10 years. While this should boost growth and inflation, its overall impact is expected to be somewhat muted on both fronts. Tax cuts are likely to be on the softer side of current expectations, and if they are meaningful, the US dollar is likely to appreciate and offset some of the inflationary impact.
“Any major increase in inflation is likely to come from either US fiscal reform, currency appreciation, or a spike in the oil price or broader commodity base.”
Currency volatility should remain constrained
Volatility in currency markets, along with most other markets, has been relatively subdued for the best part of 24 months. We don’t expect this to change any time soon given that markets remain flush with liquidity and few catalysts exist to re-price currencies outside of Brexit negotiations. As such, we don’t expect the US dollar, the Euro currency or the Australian dollar to depreciate significantly over the next six to 12 months. If any currencies are at risk of depreciating, it is likely to be the British pound or the Japanese yen—but these are unlikely to promote global inflation. The pound is arguably the most vulnerable, as the UK economy is expected to weaken next year, inflation is expected to remain heightened and both the fiscal and current account deficits are likely to widen from current levels.
The Euro currency is expected to benefit from economic growth, QE tapering and a strong current account (balanced by increased Italian political uncertainty in H1 2018).
The US dollar is expected to benefit from an unwinding of QE, higher interest rates and fund flows from lower tax rates and repatriation (balanced by a worsening current account and increased debt levels).
The Australian dollar is expected to benefit from an improved global economy and current account (balanced by a contracting interest rate differential).
The price of oil is arguably the greatest inflationary threat
The price of oil is arguably the greatest potential threat to the current environment. Firstly, if the price continues to increase, this could cause a spike in inflation that is significant enough to force central banks to raise rates in unison—and perhaps aggressively. Secondly, higher energy prices would be a significant headwind to global growth, which is expected to be a driver of earnings growth.
For the most part, the potential impact of higher oil prices has been overlooked by analysts. This is due to oil’s recent low price, as well as the threat of alternative energy supplies to the long-term demand for oil. It’s important to note, however, that the price of oil has rebounded around 40% from its June lows, and if tensions continue to mount in the Middle East, the rally could easily continue—especially if there is any kind of supply shock.
“The potential impact of higher oil prices has been overlooked by analysts”
From a domestic perspective, the price of oil is also becoming increasingly important given the growth of liquified natural gas (LNG) exports. LNG prices are contractually linked to the oil price. As such, a higher oil price will benefit LNG pricing and Australia’s terms or trade and current account. While this is a positive for macro-economic data points, it is also likely to drive the Australian dollar higher, which is likely to create a headwind for the rest of the economy—particularly Australian companies that earn revenues offshore. This direct linkage to the price of oil is something new for the Australian dollar and the economy, and warrants ongoing close monitoring.
Considering these two possible outcomes, we think the probability of a positive shock to economic growth outweighs the risk of a negative shock from inflation. We continue to think that European equities are the most attractive asset class, but recommend remaining cautious on valuations, and taking a prudent investment approach.
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