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INSIGHT
HIGHLIGHTED IN THIS PUBLICATION:
Q U A R T E R LY M A R K E T R E V I E W
Q2 2017
GLOBAL STRATEGIC
ASSET ALLOCATION
GLOBAL SECURITY
SELECTION
REGIONAL
ASSET ALLOCATION
REGIONAL PORTFOLIO
CONSTRUCTION
Tranquil waters?
OVERVIEW
UK
EUROPE
SPECIAL FOCUS
Steady US expansion
continues
Brexit-related
uncertainties
Yield curve signals
recovery will continue
Small cap growth stock
OVERVIEW
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.
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.
1. Animal spirits
20
Selected confidence/optimism/business conditions
indicators compared to normal level*
Index points
15
10
5
0
-5
-10
NFIB Small
Business Confidence
ISM
Manufacturing
Low point in 2016 pre-election
ISM
Services
Consumer
Confidence
Latest (Jan 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.
…but not flowing through to actual data
Indeed, 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
2. US expansions
10.0
7.5
1
year
5.0
92
months
93
months
73
months
4.3%
3.6%
% 2.5
2.7%
1.8%
0.0
-2.5
-5.0
1980
1985
1990
US GDP % change on year
1995
2000
2005
2010
2015
Expansions
Average
Sources: NBER, Thomson Reuters Datastream as at 3 April 2017.
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 “revvedup” 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 tax
One key aspect of tax reform is the Republican Party’s own
plans for a ‘border tax adjustment’ (BTA), which pre-date
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
2 | Insight Q2 2017
120
months
OVERVIEW
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 reflation
There 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 trends
Currency 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.
4. Swiss franc and pound sterling
3.00
USD per CHF & GBP
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.
Plaza Accord
22 September 1985
2.50
2.00
1.50
1.00
Bretton
Woods
system
0.50
0.00
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Number of US dollars bought with:
3. China: PPI and GDP
1 Swiss franc
1 Pound sterling
Source: Thomson Reuters Datastream as at 3 April 2017.
%
16
28
12
24
8
20
4
16
0
12
-4
8
-8
4
-12
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16
17
We return to these themes after a discussion of recent
asset market performance.
%
0
Producer prices, % change on year
Nominal GDP, % change on year (rh axis)
Source: Thomson Reuters Datastream as at 3 April 2017.
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/
Insight Q2 2017 | 3
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.
Asset market performance
Over 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.
6. Bond market returns
8
6
4
%
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).
5. Asset market performance
2
0
-2
Eurozone
US
Canada
Switz.
New
Zealand
UK
Japan
Australia
Local currency terms
US dollar terms
Source: Citigroup. Data for three months to end-March 2017.
14
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.
12
10
8
% 6
4
2
0
-2
US
Europe
Japan
Emerging
World
Bonds, total returns, US dollar terms
Equity markets
Asian 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.
Equities, total returns, US dollar terms
Source: Citigroup (bonds); MSCI (equities). Data for three months to end-March 2017.
Bond markets
The 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
4 | Insight Q2 2017
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.
7. Equity market returns
20
15
10
% 5
0
-5
-10
Russia
UK
Japan
Local currency terms
Italy
US
Switzerland
China
India
South Korea
Germany
Brazil
Spain
US dollar terms
Source: MSCI. Data for three months to end-March 2017.
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 trends
The 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 nonpartisan 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.
9. US government debt
30
25
8. US government finances
USD trillion
24
23
22
21
% of GDP
2016: US$14.2tr
77% of GDP
20
25
15
10
2008: US$5.8tr
39% of GDP
5
20
19
0
18
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Debt USD trillion, pre-Trump election
17
Debt USD trillion, post-Trump election
Sources: US Congressional Budget Office (CBO), January 2017 (‘pre-Trump election’ projections) and Committee
for 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
16
15
14
1965
1975
1985
Revenues
Revenues post-Trump election
2024: US$24.3tr
98% of GDP
1995
2005
2015
Outlays
Outlays post-Trump election
2025
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.
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.
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 debt
Is 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.
In the words of Kim Wallace, RenMac, speaker at the EFGAM Knowledge Exchange, January 2017.
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.
3
4
Insight Q2 2017 | 5
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.
UK economy holding up
For 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 vulnerability
The 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
10. UK real wage squeeze
7
6
% change on year
5
4
3
2
1
0
-1
-2
-3
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Total wages, 3-month moving average
CPI inflation
11. UK current account deficit
0
-5
Deficit as % of GDP
Brexit uncertainties
Two 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.
-2.6 -2.8 -3.4 -3.4
-3.6 -4.4
-10
-8.1
-8.8
-12.2
-14.4 -15.0
-20
-25
-30
-24.8
Mexico
US
South
Africa
Colombia
Turkey
Egypt
UK
Thailand
Portugal
Estonia
(1996)
(2008)
(2007)
Iceland
Spain
Greece
(2008)
(2007)
(2008)
Mexico
(1994)
Current account deficit as % of GDP, 2017
Previous crises
Source: Economist Poll of forecasters, 11 March 2017. Data for Mexico, Thailand, Spain, Portugal, Greece,
Estonia and Iceland refer to their ‘crisis years’.
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 fastestgrowing 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.
“Mark Carney fears Brexit would leave UK relying on ‘kindness of strangers’ ”, The Guardian, 26 January 2016.
6 | Insight Q2 2017
-7.2
-15
Source: Thomson Reuters Datastream as at 3 April 2017.
6
-6.2
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 confidence
A 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).
12. Eurozone: an uneven recovery
GDP Index, pre-crisis peak = 100
108
106
104
102
100
98
96
94
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 track
Eurozone 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 mid2013, 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.
13. Eurozone yield curve
92
90
2007
2008
Germany
France
2009
2010
2011
2012
2013
2014
2015
2016
2.5
2017
24 March
2.0
Italy
Spain
1.5
Source: Thomson Reuters Datastream as at 3 April 2017.
Foreign inflows
Attitudes 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.
r 2016
16
30 June 20
r 2015
31 Decembe
1.0
%
2017
30 Decembe
0.5
0.0
-0.5
-1.0
3m 9m 2y
4y
6y
8y 10y 12y 14y 16y 18y 20y 22y 24y 26y 28y
Maturity (months/years)
Source: Bloomberg as at 3 April 2017.
Easing political concerns
Although 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
7
Search for yield
The 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 oftenoverlooked 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.
Source: EPFR Global data to 29 March 2017.
Insight Q2 2017 | 7
JAPAN
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.
Headline, ‘core’ and ‘core-core’ inflation
The 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.
14. Japan: edging away from deflation
4.0
3.0
2% Target
2.0
% 1.0
0.0
INFLATION
DEFLATION
-1.0
-2.0
2010
2011
2012
2013
2014
2015
2016
2017
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’)
Sources: Bank of Japan, Thomson Reuters Datastream as at 3 April 2017.
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.
8
Krishna Guha, Evercore ISI, at the EFGAM Knowledge Exchange, January 2017.
8 | Insight Q2 2017
15. Long-term inflation trends
4.0
3.74
3.40
3.0
2.42
2.0
1.0
%
0.11
0.0
-0.10
-0.10
-1.0
-1.70
-2.0
-3.0
-2.40
-2.52
Core
Headline
Core-core
Average inflation since 1994
Maximum
Minimum
Average
Sources: Bank of Japan, Thomson Reuters Datastream as at 3 April 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 fulltime 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.
16. Japan: wage trends
3.0
2.0
% change on year
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.
1.0
0.0
-1.0
-2.0
-3.0
2012
2013
2014
2015
2016
Full-time monthly wages
Part-time hourly wages
Sources: Thomson Reuters Datastream and JBRC (http://jbrc.recruitjobs.co.jp/data/index.html)
2017
ASIA
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 recovery
Asia 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).
18. China: contributions to GDP growth
14
12
10
8
6
% 4
17. Asian exports
2
0
% change on year, USD terms
40
-2
-4
30
-6
20
10
2010
2011
2012
2013
2014
2015
2016
2017F
Net exports of goods & services
Gross capital formation
Real GDP
Source: National Bureau of Statistics China as at 3 April 2017.
0
-10
-20
2011
Taiwan
2012
2013
2014
2015
2016
2017
Korea
Source: Thomson Reuters Datastream as at 3 April 2017.
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) economy
While 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
2009
Final consumption expenditures
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 spending
Consumer 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.
Bain & Co, Luxury Goods Worldwide Market Study, Fall-Winter 2016, 28 December 2016.
Insight Q2 2017 | 9
LATIN AMERICA
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 Ross
Mexico 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.
19. Mexican peso pre- and post-Trump‘s election
20
% 15
10
5
02 03 04 05 06 07
08 09 10
11
12
13
14
15
16
17
Source: Thomson Reuters Datastream as at 3 April 2017.
18
USD:MXN
25
Brazil’s official interest rate
Consumer price inflation rate
17
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.
19
21
30
0
2000 01
16
20
20. Brazil: interest rates and inflation
Weaker
peso
22
23
Jan Feb Mar Apr May Jun
Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr
2016
US dollar : Mexican peso
2017
Trump election victory
Source: Thomson Reuters Datastream as at 3 April 2017.
Self help
Indeed, 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%.
Brazil
Brazil is in a different position. The central bank has cut
rates from 14.15% to 12.15% over the last six months (see
10 | Insight Q2 2017
From Venezuela to Argentina
The 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.
21. Stock market performance
40
35
30
25
% 20
15
10
5
0
Mexico
(IPC)
Brazil
(Bovespa)
Chile
(IGPA)
Argentina
(Merval)
Stock market % change, 31 December 2016 to 31 March 2017
Sources: Thomson Reuters Datastream as at 3 April 2017.
Venezuela
(IBC)
SPECIAL FOCUS – US SMALL CAP GROWTH STOCKS
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 stocks
Historically, 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.
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).
24. US tech sector funding
22. Small cap growth versus large cap stocks
US$19.0bn
20
18
16
60
USD billion
Total return in year (%)
14
40
20
12
10
6
0
4
-20
0
2
-40
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
Small cap growth stocks (Russell 2000 Growth Index)
Large cap, all stocks (S&P 500 Index)
Source: Thomson Reuters Datastream as at 3 April 2017.
De-equitisation
Public listings have, however, become less popular for
US companies. The US equity market is becoming “deequitised.” 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).
23. US: listed companies in decline
809
8
US$4.3bn
26
IPOs
(Initial Public Offerings)
Amount raised in 2016
PE
(Private Equity)
Number of times accessed
Sources: Dealogic and Dow Jones VentureSource as at 3 April 2017.
Advantages of being private
In 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.
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
1980
1985
1990
1995
Number of domestic US-listed companies
Source: World Bank as at 3 April 2017.
2000
2005
2010
2015
Creative destruction
Although 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.
Insight Q2 2017 | 11
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