The capitulation of market sceptics in the past several weeks has not been pretty. But it was perhaps inevitable, and so, as we look to 2014, the consensus among market strategists has hardened.
The Federal Reserve is expected to start tapering asset purchases in the first quarter of next year, if not sooner, but investors should keep the faith, and remain committed to the near five-year-old bull market in equities.
The protagonists have a point. In the face of a firmer cyclical economic outlook, all developed country central banks are committed to an extended period of zero-bound interest rates. In addition, markets can look forward to additional ‘QE’ in Japan, and other ways of easing monetary policy in the eurozone. But those of us being encouraged to part with our money would be well advised to remember that whatever the justification for rising stock prices, we should not let economic fundamentals get in the way of the story.
Looking back over the past year, almost three-quarters of the rise in global equity returns came from the re-rating of price-to-earnings ratios, which are now touching a long-run average (ex-technology bubble) of around 15, which is what they did in the 2009-10 rally, before trending down again until 2012.
The cheerleaders argue next year we will get upside earnings surprises, from an acceleration in global growth, higher capital spending by cash-rich large companies and rising operational leverage as margins increase. We could even get higher p/e ratios because the abnormalities of the 2008-13 period, including the financial crisis, recession, deleveraging and euro-break-up threat, are now history. Instead of the narrow 10-15 range for p/e ratios that describes most of the past six years, why not the more “normal” 12-25 range of the past quarter century?
For these things to happen, though, two propositions must hold. First, global growth has to accelerate, and become self-sustaining, and second, the “bad cycle” of 2008-13 must really be over, leaving no detritus behind. Neither stands up to scrutiny. The former is fickle, while the latter is fantasy.
There is a modest cyclical pick-up and it might have legs in the US – if a dysfunctional government can avoid another bout of untimely fiscal drag. But, other than a surprisingly perky UK, which has embraced the housing equivalent of recidivism, European growth is stagnant, even if it has a ‘+’ sign in front of it next year, thanks to a lull in structural fiscal adjustment. Japan’s economy is predicted to slow to almost a standstill in 2014, amid a tax rise and continued weakness in wages, hiring and investment.
The western economies, more importantly, cannot achieve self-sustaining growth until they address structural economic drags that have been accumulating for many years.
Foremost among these are the cumulative effects of rising age structure, weak capital spending rates and an array of labour market weaknesses, including the stagnation of wages, the fall in employment and labour force participation rates, and the massive substitution of low wage for middle wage jobs. With much of the western world experiencing low single-digit money GDP growth or deflationary risks, the chances for aggregate upside earnings surprises do not look bright.
Fed tapering will have pervasive consequences for many emerging markets, struggling with their own structural growth slowdowns, as will the separate issue of credit cycle management in China.
The former will build on the hors d’oeuvre earlier this summer as more fixed income and currency market turbulence lead to lower growth. Managing China’s credit cycle is becoming more urgent and fractious, for while total social financing and money GDP growth have slowed since 2009 and until now, TSF is growing at twice the rate of money GDP, versus 1.5 times in 2009. The credit to GDP ratio of 230 per cent, therefore, is actually growing more quickly. To stabilise it, let alone deleverage as the People’s Bank has suggested, short-term interest rates will rise again, feisty bond market conditions will likely tighten further, and 7 per cent growth may be a new year casualty.
Away from the global economy, then, the bullish case for equities is largely down to the issue of money, or central bank largesse and persistent zero rates in the US and elsewhere. Investors should note JK Galbraith’s reference to the world of finance, where people have short memories in which “past experience is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present”.
Past and relatively recent economic experience warrants caution about the market. More of the same from central banks warrants commitment. But which do you trust more? Faites vos jeux.
George Magnus is an independent economic consultant, and former chief economist of UBS