Welcome to the August edition of the Burrell Blog for 2018.
‘Mid Cycle’ or ‘Late Cycle’
For more than a decade your diarist has enjoyed and benefitted from a monthly lunch time discussion with Bernard Rowley, the independent chair of Burrell. The insights from these discussions will remain a highlight of professional life during that period. A few weeks ago Bernard was keen to talk about an article reported in the Australian Financial Review. The article under the above heading concerned a report by Deutsche Bank’s chief international economist, Torsten Slok. Slok has been based in New York for the past 13 years. His comments concern the US economy. This encouraged your diarist to locate the original paper, some aspects of which are summarised below;
- “What do the fundamental metrics indicate as to how advanced the cycle is? The long duration and measures of slack in the labour and output markets unambiguously suggest the cycle is very late. By contrast almost all other indicators, ranging from inflation or cost pressures generated by that limited slack, the cyclical components of demand (housing; durables, and investment spending), confidence, corporate and household leverage, delinquencies and default rates, bank lending standards, margins and earnings, all suggest mid- or in some cases even early-cycle.
- The ‘late’ cycle phase when slack is limited can go on for quite long. Limited slack by itself does not end the cycle. What it does is either cost pressures that it generates or stretch spending, leverage, overconfidence or other excesses that it has historically coincided with. None of these currently appear to be in place. In the last 3 cycles, the late cycle phase lasted 2-4 years which in the current context would put the next recession potentially as far out at 2021. With core inflation having fallen short of the Fed’s target of 2%, sticking to its current guidance, possibly moving it up modestly. Moves up in the labour force participation rate, an increase in productivity growth and a higher dollar, all of which are elements of our baseline view, would act to lengthen the cycle.
- Getting out early can be costly. Average market returns during the late-cycle phase have not been particularly different from the mid-cycle phase. So historical ex-recession annual price returns of 12% are a reasonable indicator of potential returns in this phase. The timing of the move from late to end cycle is always unclear in real time and if the cycle goes on for longer would imply significant foregone returns amounting for example to median cumulative 42% during the late cycle phase of the last 3 cycles.”
In an interview on the 5th of August 2018 Slok made the following additional points;
- On inflation: ‘if I add these things together, we are at full capacity, the dollar is going down, we did a fiscal expansion, the trade war and tariffs talk is also lifting prices modestly, we do think that by the end of this year, inflation and here, we are talking about core PCE will be well above the Feds 2% target because the Fed has a 2% target’
- Still on inflation, on the argument that technology, globalisation, Amazon etc is holding US inflation down: ‘the weight in the CPI to goods is about a third and the weight in the CPI to services is about two thirds. And what is services? Housing makes up 40% of the CPI overall. Healthcare makes up about 20% of the CPI. Healthcare costs also are going up, also is not subject to globalisation pressures or Amazon pressures. And finally education costs also make up a significant share of CPI’
- On central banks buying government bonds: ‘Central bank, and now the fed has been buying their own government bonds, the ECB has been buying their own government bonds, the BOJ has been buying their own government bonds… So the issue is that it really is true that markets are distorted by the very significant amount of asset purchases or QE has been carried out by the three major central banks and therefore, the exit which is what we are beginning slowly to go through with the Fed raising rates, next year the ECB will raise rates. Eventually the BOJ will raise rates, the exit will be associated with some unwinding of those distortions.’
- On the US economy: ‘we should see solid consumption growth for the rest of this year, we should see solid CapEX growth because CapEX also got incentivised by the design of the US fiscal package to also grow continuously. So the answer to your questions is that we still think equities will do well, we still think rates will slowly go higher, the Fed will gradually hike rates, we think because of all these problems we spoke about earlier with trade, because of some of the issues generally in the relative value of assets in the US we do think the dollar will be down, but generally speaking equities should continue to do well and the PE ratiowe’ve got some adjustment… So there’s definitely still more room for equities to rise from here because the economy is not about to enter recession, if anything, the risk will begin when the economy is about to overheat.'
Possible X Factor
The Slok view above is consistent with ongoing economic data from the US and also with an above average US reporting season, driven both by the decrease in the tax rate from 35% to 21% and by the economic growth noted in the previous section. In Australia we know the greatest risk to the US may be a myopic view of the world – it is potentially the greatest strength but also the greatest weakness of the USA. In Australia we need to continually assess where an X factor may come from. For example, has Trump made a fatal error in firing the former FBI chief, will the US electorate in the mid-terms elect a majority Democrat congress? (The democrats only require to flip 24 seats to control the house. 68 seats are less conservative than the recent Ohio special election). Any member of congress can bring articles of impeachment, which if approved require a two-thirds majority of the US Senate (unlikely). Might the democrats follow the Australian Labor Party policy successful in recent by-elections by saying that the US corporate tax cuts go to the wealthy when middle America can only open some schools four days a week, requires massive injections of funds for healthcare and infrastructure and that the tax cuts need to be reversed. Fundamentally 21% is an unsustainable tax rate for an advanced economy with health, education and social security services.
The central case is there will be no reversal of the tax cuts until the end of this presidential term, more than two years away. The first half of 2019 calendar year could be interesting.
The Slok analysis of a strengthening US economy is supported by US economic data. What is less certain is the correlation of macroeconomic data such as GDP growth and movements in US stock market valuations. The US stock market valuation multiples were looking high, but have reduced because of the US corporate tax rate cuts which increase after tax earnings per share (eps) to reduce P/E valuation multiples. Earnings of US corporates are strong with many US companies experiencing increases in eps. Any change in US policy would likely reverse the momentum of the US stock market.
Australia is not in lockstep with the US with lower share market appreciation and a mixed reporting season completed today.
Both markets are more deserving of individual stock research to separate quality companies at fair to attractive valuations from the remainder. The remainder will suffer greater volatility from any change in broader market inputs and sentiment.
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