Tuesday 14 November 2017 by Craig Swanger Opinion

Not too warm; not too cold; but not really Goldilocks economy either

In the previous two parts of this series, I covered the arguments for and against the return of inflation. Now it’s time to look at these arguments in the context of today’s economy and the likely environment over the next 10 to 20 years

goldilocks

In the past few years, the global economy has shown signs of breaking out into economic growth periods like those we were accustomed to prior to the GFC. It has also shown periods of deflation and economic malaise. The US economy has recovered, showing broad based economic growth across most sectors and most socioeconomic groups for the first time since the 1990s. On the other hand, Japan remains in its decades long slump and Europe, outside of Germany, remains socially and politically fractious and economically very weak.

Unsurprisingly, economists and investment managers cannot agree on the near future of the global economy, let alone the next two decades. There are three schools of thought simplistically grouped into the Bulls, the Bears, and the Muddle-Through camp. Each has very different implications for interest rates. I fall into the last of these groups, as readers of the WIRE well know. However, as always I encourage you to read the evidence and form your own view. Below is a summary of each of these positions:

1.   Global Economic Bulls

Under this scenario, the four global economic engines – the US, the EU, China and Japan –all implement the structural reforms necessary to boost potential growth, or in the case of China, to reduce the risk of a credit crisis. Doing this as the global economy is recovering (as it is now) would extend the recovery for several more years. 

That scenario would allow equity markets to rise further, or at least to maintain current levels as economic growth pushes up earnings and lowers price/earnings (PE) ratios to normal levels. It would also result in interest rates rising; first in the US with four to six increases over the next two years before stabilising into the new normal equilibrium rate of 2-3% per annum.

2.   Global Economic Bears

By comparison, this camp believes that nationalist, populist politics will prevent reforms in the US and Europe, and that the Chinese will choose not to slow credit growth, instead favouring GDP growth at current levels. 

The Bears also believe that financial markets face unprecedented valuation bubbles.  For example, the front page of the uber bear, but credible publication, The Economist, on 7 October 2017 was, “The bull market in everything”. The theory is that QE, while not causing consumer goods inflation, has caused financial markets inflation. 

Company earnings in the US in particular have finally started to rise, but for a long time share prices rose while earnings remained flat. As a result, PE valuation ratios were pushed to near record highs where they remain today.  Headlines like “QE extended due to weak economy; sharemarkets rejoice” were common, highlighting the addiction financial markets developed for cheap debt. 

The question remains whether the stimulus created by QE has left financial prices artificially high. Long term valuation multiples such as the “CAPE-10”, a 10 year price-earnings ratio that is considered one of the best indicators of fair pricing for equities, are now at levels only beaten in 1929 and 1999, immediately prior to two of the largest financial asset corrections in history.

In this scenario, interest rates remain low and long term bond yields fall further as QE measures in Europe and ultra loose monetary policy is required for longer than currently expected.  US rates still rise but only two to four rises in the next two years before the higher USD hurts competitiveness and ends the US recovery. China is the biggest loser in this scenario due to its already high leverage but mostly due to its dependence on global demand.

3.   Muddling through

Then there is the middle ground, which is a real mixed bag.  In this scenario, the US economy continues to recover despite the ineffectiveness of the Trump administration to effect change.  Europe achieves none of the necessary reforms to continue and affirm integration.  This is caused by Germany continuing to avoid risk sharing, maintaining its economic advantage over the rest of Europe such that populist movements in the rest of Europe continue to prevent reform.  Finally, China does the minimum required to curtail further credit growth enough to avoid a hard landing, but its economy eventually grinds slower as new productive assets become harder to justify.

In this scenario:

  • Global economic growth rises slightly in 2018, but then slides back in 2019 and 2020
  • Interest rates in Europe and Japan remain ultralow with their QE programs continuing 
  • US peaks at 2-3% GDP growth before full employment and rising rates, and therefore a rising USD, constrain further growth

What these scenarios mean for inflation, rates, currency and equities

Scenario Inflation Interest rates Currency Equities
Bull US inflation exceeds Fed target, but other economies remain below due to Amazon effect
  • US: 4-6 rate rises 2018/19; 10yr rate ranges 2.5%-3.5%pa, settling 2.5%-3.0%pa later
  • Australian 10yr rates remain slightly above US
AUD/USD fair value rises to 75-80c; rises steadily over the long term as China continues to progress Earnings rise with economic growth allowing PE ratios to return to more sustainable levels. Returns lower than historic, but positive
Bear Excess capacity and Amazon effect combine to produce very low inflation over the next 5 years at least
  • US: 2-3 rate rises 2018/19; 10yr rate remains closer to 2.5%pa
  • Australian 10yr rates fall below US due to US relative strength but more so China weakness
  • AUD/USD falls to 60-70c range, with potential to fall lower depending upon severity of China credit crisis
  • EUR downside risk
Markets very sensitive to downside shocks due to the current extreme valuations. 20%+ correction is likely 
Muddle-through Inflation remains below central bank targets globally

US: 3-4 rate rises 2018/19; 10yr rate remains 2.5%-3.0%pa

  • AUD/USD fair value remains around 70c
  • EUR, JPY and GBP subject to more downside risk than upside
Returns very muted as earnings struggle to rise to justify PE rations. Risk of a major correction is low, but returns remain 4-6%pa for 10yrs or more



Conclusion

This series on inflation and interest rates has been all about presenting all sides of the argument to allow the reader to make an informed decision. With this in mind, here’s my view, which will be no surprise as it really hasn’t changed much in the past few years:

  1. Inflation will remain very low, due to both excess demand after years of excessive investment in capacity caused by cheap debt, and China’s credit boom; also the Amazon effect which has a multi decade impact on consumer prices.
  2. Real interest rates (interest rates net of inflation) will remain low by historic standards largely because each of the major economies has a sector that just can’t afford a large increase in rates before they will cut spending.  In the US and Europe that is the government sector; in China it is the corporate sector (albeit state owned); and in Australia it is the household sector. 
  3. Europe and Japan in particular face a transition period to shrinking populations. Both need to boost exports in order to maintain employment demand and earnings which means keeping currencies competitive, which in turn means lower interest rates. 
  4. Combining these, the new normal that investors need to adjust for and preferably before everyone else wakes up to, is for interest rates around 2-3%pa lower than historic averages across the world.  These lower rates will:

a.   Help justify equity prices, but equity returns will be just 4-7%pa in future instead of the historic 6-9%pa averages
b.   Create a period of lower defaults in most industries due to lower interest rate volatility, but higher defaults in more volatile industries such as resources
c.   Compress credit spreads and create capital gains in corporate bonds and any other yielding assets as the colossal pool of baby boomer pension capital goes looking for yield


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