A Contrarian View to World Growth

Matthew Seaward
June 22, 2018

A roller-coaster ends up in the same place it started. Yeah, but it is still a roller-coaster.

While at present there are significant tailwinds pushing US markets higher including impressive earnings, share buybacks and takeover activity to name but a few, rising interest rates and quantitative tightening (the scaling back of central bank asset purchase programmes) are a significant threat to the synchronised global growth story.

This is the first time in history that we have had the reversal of unconventional monetary policy (QE) as well as the traditional method of tightening monetary policy (interest rate increases). In our view, this has to increase the likelihood of a central bank policy error going forward.  This year, the US Federal Reserve is expected to rise rates four times. Two have already occurred, taking the base rate of interest to between 1.75% and 2%. This, coupled with the effects of quantitative tightening, is more akin to six to eight rate rises.

Q1 earnings growth in the US was initially predicted at 18%, which initially appeared lofty. However, this target was exceeded, with the final figure coming in at 25.6%. For Q2, US companies with significant global exposure are expected to outperform their domestically focused peers. Companies that generate more than half of their sales outside the US are forecast to grow earnings by 23.9%, while companies generate more than half of their sales domestically are expected to grow earnings by a still impressive 16.5%. This appears to re-affirm a strong global growth outlook, and the forward 12-month price-to-earnings (P/E) ratio for the S&P 500 index is only slightly higher than the 5-year average (16.6x vs. 16.2x), suggesting that valuations are not overly stretched.

Although the underlying sentiment indicators are bullish, there are other indicators which tell a different story.  The Shiller P/E or Cyclically Adjusted P/E (CAPE) is the price, divided by the average of ten years of earnings, and then adjusted to account for inflation. It was designed to provide a more reliable indicator than the traditional P/E ratio, because earnings over one year appeared too volatile to offer a better idea of the true earnings potential of a company. Many academics believe that a long moving average of real earnings helps to forecast real returns, and this smoothing effect has been a very useful indicator historically. Since 1881, there have only been three periods in which the CAPE has surpassed 25, which were the years 1929, 1999 and 2007. These marked major market peaks, and were followed by significant recessions. At present, the CAPE ratio is around 32 which, when coupled with QE tapering and rising rates, indicates to stretched equity valuations.

However the CAPE itself is fallible. For example, a collapse in earnings after the financial crisis meant that the Schiller P/E ratio signaled an over-valuation in stocks. This turned out to be an incredibly good buying opportunity, of course. Other issues include changes over time in inflation measurements, accounting standards and taxation policies. This makes comparisons of the ratio over time increasingly unreliable.

Some commentators have suggested that this present period might be similar to the 1983-1989 period of extended growth. However, there are also similarities to that of the tax cuts of 1981. In 1983, the US was coming out of normal “V” shaped recession. According to research by Reinhart and Rogoff, this, coupled with the present DEBT to GDP in the US of 105%, means that there will be no, or slow, growth in the US. The jury is still out on whether high public debt consistently stifles economic growth.

The dollar as the present leading international currency is considered a safe haven because 60% of the global currency reserves, 80% of global payment and almost 100% of oil is priced in dollars. Thus, the US has a major advantage, as they are able to effectively borrow at much lower interest rates because of the prominent demand for dollars. There is also a significant amount of emerging market debt denominated in dollars, so the Fed can also devalue much of the world and effect emerging market debt markets more than any other nation in the world.

One of the main reasons for the rise of the dollar as a global reserve currency was because of the Bretton Woods fixed exchange rate system; an exchange rate that fixed the dollar to gold at the rate of $35 per ounce. This was then devalued in December 1971 to $38 per ounce. It was eventually scrapped in January 1973 and a new floating exchange rate was implemented.  Although the exchange rate was no longer fixed, the dollar remained the global reserve currency because market participants still continued to view it as a safe heaven and conduct business in this supposed ‘global currency’.

In the course of human history, one of the most important metals has been gold. Gold has played an important role as money, as a medium of exchange, and as both a store of value and unit of account. With the advent of modern paper currencies, gold has lost its role as a medium of exchange. However, until the collapse of the Bretton Woods fixed exchange rate system, it continued to play a role as a real anchor. After the collapse of this exchange mechanism, the IMF sold its gold and market participants absorbed this supply in order to become part of their investment portfolio as a hedge against other assets. The gold price acts slightly differently to most other storable commodities, as most of the demand for gold is from jewellery and investment use, and the annual new supply is only around 1-2% of its existing stock. This makes releases of existing gold stocks into the market more important drivers of gold price than the new supply, which comes from two main sources: mining and scrap metal. Much academic literature supports this hypothesis, and the argument that gold miners are ‘price-takers’ and not ‘price-makers’. Moreover, Borenstein and Farrell (2007) found no mention of any supply shocks having an effect on gold prices when searching through 28 years of Wall Street Journals.

Although renowned investors like Warren Buffet openly dislike gold because of its limited utility and its non-existent earnings, the graph below strongly suggests that gold has not actually been a bad investment over the past 15 years, with an ounce of gold still able to purchase the same amount of the index.

Gold is often thought of as a hedge against other financial assets, with it supposedly being uncorrelated, or negatively correlated, with traditional portfolio assets. Although I have seen academic research finding almost no real return and volatility spill over to gold from US stock and bonds, other articles find it is a weak hedge. Gold and real interest rates are thought to have an inverse relationship, which makes sense because ultimately both treasuries and gold are competing for investors’ dollars. Over the next 15 years, it will be interesting to see if gold keeps up with inflation and/or other global indices.

Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

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