International Equities

A global economy far from “normal”

The sort of self-sustaining growth that the global economy had enjoyed for generations has disappeared.
June 2019
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Election fever hit India and Australia in May. The former, the largest democratic election in the world, resulted in a comfortable win for the incumbent – Narendra Modi and his Hindu Nationalist Party (Bharatiya Janata Party). Mr. Modi comes from a humble background and this appears to have resonated with millions of voters aspiring to a similar uplift in fortunes. Among other things he has promised free medical insurance, 100 new airports and the installation of 100 million toilets – something that matters in a country deficient in basic sanitation.

We have long admired the economic potential offered by India but, like many, been frustrated at sclerotic government and administration, mountains of red tape and the struggle to adequately educate the approximate 47% of the population that is under the age of 24 (a mere 650 million people). This is the start of Mr. Modi’s sixth year in office – we hope that he, and India, don’t squander this latest opportunity.

Australia sprang an election surprise. All the pre-election polls had the Labor opposition taking power from the center-right Liberal National Party (LNP). However, within a few hours from the start of vote counting it became apparent that Scott Morrison (the Prime Minister) and his coalition would not only win but achieve an absolute majority in Parliament – thus avoiding the complication of relying on minor parties or independents to govern.

How could the polls be so wrong? That debate will rage on and on, but it does bring into question the value of the ever-blossoming number of opinion polls. Can people be relied upon to tell the truth when polled and who are these people anyway? Have you ever been polled?

In a typical pre-election give-away Mr. Morrison promised that the government would provide a guarantee for first home buyers for the gap between a 5% deposit on a property and 20% – in other words, asking the taxpayer to fork out for borrowers who overstretch and default on their payments (the Labor Party promptly promised the same). All this will do is push up house prices and cement Australia’s place at the top of the household debt to income table. Politicians in Australia constantly babble on about making housing affordable but to our simple minds there is only one way to do that – get house prices down, not up. But that, of course, is the short route to a political graveyard.

Known for its merry-go-round of Prime Ministers (six in the last nine years) there is now a chance of at least three years of stability as that is the theoretical duration of the Australian election cycle. The public is weary of political machinations and flip-flops. Mr. Morrison has now earned himself a level of authority not enjoyed by any recent holders of the top job. We hope it is used wisely.


The latest Economic Outlook from OECD

The OECD has released its latest Economic Outlook and in keeping with the recent IMF World Economic Outlook has lowered growth forecasts and emphasized downside risks. “Global momentum has weakened markedly and growth is set to remain subpar as trade tensions persist. Trade and investment have slowed sharply, especially in Europe and Asia. Business and consumer confidence have faltered, with manufacturing production contracting. In response, financial conditions have eased as central banks have moved towards more accommodative monetary stances, while fiscal policy has been providing stimulus in a handful of countries… Moreover, the global economy remains largely dependent on persistent policy support. Ten years after the financial crisis, with subdued inflation, central bank balance sheets remain at unprecedented levels, interest rates – short and long-term – are historically low, and government debt, except for a few cases, is much larger…In short, central banks have barely normalized the monetary policy stance and their support remains essential.”

The latter comment resonates – the world economy is far from “normal” and is on constant central bank (and central government) life support. The sort of self-sustaining growth that the world enjoyed for generations has disappeared. Instead we depend on ever-growing mountains of debt and interest rates that are unrecognizable to anyone over the age of 30.

In a comment that mirrors our views the OECD remarks: “An apparent disconnect between recent equity market dynamics and projected corporate fundamentals may signal a risk of correction…expected corporate earnings growth has continued to be revised down due to projections of weaker economic growth, increased labor cost pressures on profit margins and, in the United States, the waning effects of the corporate tax reduction.”

A considerable amount of the OECD release refers to the dangers of a step-up in the U.S./China trade stoush. We concur. An increase in tariffs pushes up prices and lowers long-term growth prospects – everywhere. The U.S. has now imposed a 25% tariff (up from 10%) on U.S. $200 billion of Chinese imports and issued notice that the process of implementing tariffs on the country’s remaining imports of around U.S. $300 billion has been initiated. Unsurprisingly the Chinese have retaliated – even hinting they may use their dominance of the production of rare earths as a trade weapon. We despair. In an extraordinary series of tweets the American President ended with the comment that he loves collecting “BIG TARIFFS”. We muse on the sort of economic textbook that Mr. Trump employs for leisure-time reading.


Updates in Europe: May out

In the meantime the Brexit circus has finally resulted in the political death of Theresa May, the British Prime Minister. Mrs. May has announced she will resign her office on June 7th although it may take until the end of July for a new leader to be appointed. The queue at the door of Number 10 Downing Street has started forming with the colorful former Foreign Secretary Boris Johnson installed as an early favorite although he will face ferocious opposition. The public is clearly weary of the whole Brexit farrago. Just get this over with – one way or the other – is the oft-heard comment. It is surprising that the British economy hasn’t seriously faltered. The removal of uncertainty after it is “done” – whatever “done” may be – will bring a collective sigh of relief.

In the European Union elections in which all 28 member states elect representatives to the European Parliament the Brexit Party (a single-issue Party just a few months old) headed by Nigel Farage stormed across the line in Britain with 32% of the vote whilst the Conservatives limped home in 5th place with just 9% of the vote. The Labour Party secured 14%, the Liberal Democrats 19% and the Greens 11% (all percentages rounded). The poor showing by the Conservatives and Labour reflects disillusionment about the way the Brexit process has been handled. The voting public seek clarity about the way forward – not political infighting and obfuscation. Nigel Farage taps into populist sentiments and is an accomplished media performer – something that matters a lot in modern day politics. The next general election in the UK is scheduled for 2022 and the performance by Farage and his team is a significant shot across the bows of both major parties.

Elsewhere in the EU the results are fragmented but the winners appear to be the Greens and Liberals whilst the losers are the mainstream center-right and center-left parties that have dominated for decades. The cozy and predictable political landscape in Europe has been shattered. Pro-EU parties still hold sway throughout Europe but in France, Poland, Italy and Britain the opposite is now true. Quite where it all heads next is impossible to forecast.


Details of the Financial Stability Report

During May the U.S. Federal Reserve released its Financial Stability Report and it highlights a trend that has caused us consternation for some time – increasing leverage in corporate America. The Fed comments: “Borrowing by businesses is historically high relative to gross domestic product (GDP), with the most rapid increases in debt concentrated among the riskiest firms amid signs of deteriorating credit standards… Alongside these developments, standards and terms on business debt have continued to deteriorate…loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior.” Our comment: Will they never learn. It is said that each generation forgets the lessons of its forebears, but it is only ten years since the financial crisis – surely it is not too much to expect memories to stretch back as far as that traumatic period.

On the positive side the Fed notes that U.S. household debt has been growing at a slower rate than GDP since the financial crisis. But this sober and sensible behavior has been more than offset by the Federal and State governments and corporates. The overall non-financial debt to GDP ratio is higher now than before or during the crisis.


Pakistan bailed out again

In what is surely a record that is nothing to be proud of Pakistan was awarded its 22nd bailout by the IMF during May. The amount awarded is U.S. $6 billion and is in addition to substantial sums being received from the World Bank and Asian Development Bank. The IMF bailout comes with many strings attached – such as ending subsidies in the power and agricultural sectors and giving up central bank control of the currency. When announcing the bailout Pakistan’s recently appointed “advisor on finance”, Abdul Hafeez Sheikh, commented that the country faced an annual funding deficiency of U.S. $12 billion.

Pakistan’s popular Prime Minister, Imran Khan (elected in August 2018), will battle to construct his promised Islamic welfare state whilst hobbled with various restrictions and running cap-in-hand to the international financiers. We doubt that this will be the last of the bailouts.


Tesla: The cash burn continues

We rarely comment on individual companies, but it is hard to avoid Tesla, for all the wrong reasons. Just a few weeks ago the company raised U.S. $2.7 billion as a “contingency fund” but Elon Musk has now disclosed that at the current burn rate the cash will run out in about 10 months. There seem to be many problems but chief among them is the failure to produce as many of the Model 3 vehicle as planned. In April, Tesla announced that in the first quarter of this year output of all models amounted to 63,000 – almost a third lower than in the previous quarter. The 2019 target is 400,000 vehicles (mainly Model 3s). It seems a long stretch. In the meantime, the cash burn continues and loan repayments loom.

We’ve always been impressed by the Tesla as a vehicle, but we doubt that Mr. Musk fully appreciated the challenges of the global auto industry or the speed with which the well-funded and experienced opposition would ramp up research and development. Indeed, it is becoming difficult to keep up with the number of fully electric vehicles gliding off drawing boards and on to showroom floors. We’ve commented previously that the electrification surge is unstoppable thanks to subsidies and government mandates but whether Tesla remains a long-term global participant (and under current ownership) will be interesting to observe.

Posh investments- almost too extravagant?

For the lovers of French impressionist art we sadly report that it is now out of the price range of mere mortals. In mid-May one of Claude Monet’s famous Haystacks series sold at auction for U.S. $110.7 million (including commission) – a record for an impressionist work. The painting in question is titled Meules and was completed in 1890. There were six bidders at the Sotheby’s auction in New York and the whole process took just 8.5 minutes – or U.S. $13 million per minute. The painting measures 28.62 inches by 36.75 inches meaning it raised U.S. $105,228 per square inch.

We try to keep an open mind about art, and indeed admire and appreciate Monet’s work, but U.S. $100m+ for a painting? We’ve also recently seen extravagant prices being paid for classic cars whilst the demand for new-build superyachts continues at a record pace. It is clear there is plenty of loose change still rattling around in the pockets of the uber-rich. But let’s not forget, the world’s four major central banks pumped over U.S. $11 trillion into the markets in just a handful of years from the beginning of 2009. When you scatter that sort of money around some people are going to get very rich indeed.


And so to the markets…

Let’s start with government bonds as that is where there has been some fascinating action. Almost without exception benchmark 10-year government bond yields plummeted in May. In the U.S. the yield fell from 2.51% to 2.14% – the latter being 21 basis points lower than the 3-month treasury yield. Thus the dreaded inverted yield curve has struck again. In Canada the yield fell from 1.71% to 1.55%; UK yields fell from 1.18% to 0.90%; Germany from 0.01% to negative 0.17%; France 0.36% to 0.23%; Switzerland negative 0.38% to negative 0.55%; Japan negative 0.04% to negative 0.08% and in Australia 1.78% to 1.53%. The only (unsurprising) exception we can find is Italy where the yield nudged up from 2.41% to 2.52% (all data from Thomson Reuters Datastream).

So, what is going on? The short and obvious answer is that the trade conflict is stirring market nerves, global growth is slowing and inflation remains quiescent. Sometimes the short and obvious answer is the correct one. The craziness sets in, however, when 10-year yields move below zero. Can there be a more unattractive investment than a bond with a negative rate of income return? Of course, if the yield continues to fall then that will result in a capital gain for the holder. Perhaps that is driving the investors who keep lapping these bonds up (apart from the central banks). We remarked above that the world economy is in a far from normal situation – bond yields provide further evidence.

Equities had a dismal month. The trade fracas and the deteriorating growth outlook took their toll. Among the major developed markets and in order of negatives we saw the following falls: Sweden -9.7%; Singapore -9.4%; Italy – 9.1%; Hong Kong -7.7%; Germany -7.5%; France -6.6%; USA -6.5%; Japan -6.4%; Netherlands -6.1%; Norway – 4.8%; Canada -3.7%; UK -3.4% and Switzerland -2.1%. The month’s star was Australia with a positive return of 1.6% – largely thanks to the surprise re-election of the Liberal National Party coalition (all data courtesy of MSCI, local currency ‘price’ indices).

The poor showing in May has now pushed most equity indices into the red if viewed over a 12-month time frame. One of the few exceptions is the U.S. but even there the 12-month gain is only 1.7%. An investment in 10-year bonds would have provided a far more attractive return as the yield in the U.S. has fallen by more than 70 basis points over that period. Mr. Trump’s boast about the equity market strength is starting to look a little hollow.

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This material was provided by Pyrford Internation Ltd a wholly-owned subsidiary of BMO Financial Group. The value of investments can fall as well as rise and an investor may receive less than the amount invested. The investments and strategies discussed here may not be suitable for all investors; if you have any doubts you should consult your investment adviser. Performance data shown in the document may not be in the base currency of the country where an investor is based. Actual returns may increase or decrease as a result of currency fluctuations. Although the information contained herein is believed to be reliable, Pyrford does not warrant its completeness or accuracy. Pyrford does not guarantee that the views expressed will be valid beyond the date of the document.

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