Contrary to recession fears, and the plethora of ‘recession’ news stories, I believe the world economy is on the cusp of a cyclical rebound. Production, prices and exports should accelerate during the next few months, in my view. Company stocks of finished goods are low, as are borrowing costs. Central bank support is the highest for six years. The US Federal Reserve will support the US economy in the presidential election year.
The chart shows our projections (vertical bars), six months ahead, of world production data, compared to the actual announced data (continuous line). At the right of the chart our projections extend ahead of the actual data in an upwards direction: our models are forecasting a rebound in production.
Source MGI, as at 31/10/2019
Over the past year there has been lower inventory accumulation: companies have been holding less excess finished goods in warehouses or storage. With inventory accumulation low, a pickup in orders can have a sharp upwards effect on production. Factor in low costs of capital and nominal and real rates of interest, and the conditions are ripe for production to expand. The relatively stable US dollar is another positive for growth, with the shift from the Chinese yuan to the Mexican peso very evident in US trade figures.
Equities are attractively valued
Equity markets outside the US have yet to recover to mid-2015 levels, and are still down some 10% from their highs of 21 months ago. This includes the major markets in Europe, Australasia and the Far East, with shares in Japan, the UK, France, Switzerland, Germany, and Australia making up most of that market capitalisation.
The global cyclical downturn that has been underway since those markets peaked early in 2018 has brought deflationary pressures to bear again on Japanese equity valuations. Meanwhile, headwinds from bank recapitalisations and a hollowing out of Germany’s industrial base have lowered valuations of continental European shares. In the UK, sharp political dislocations have caused severe constraints on investment and credit growth, which has weighed on UK equity prices. Furthermore, over a third of the equity market capitalisation across these regions is in financials and industrials, sectors particularly disadvantaged by collapsing yield curves and contracting production during the global economic slowdown. This has meant that equities in Europe, Australasia and the Far East now have trailing price/earnings lower than was the case five years ago. In the current, record-low sovereign yield environment, earnings-yield-to-bond-yield measures, as well as dividend-yield-to-bond-yield comparisons for these regional equities are attractive relative to their averages over the past five years. Equities outside the US stand to benefit significantly from global activity and prices shifting from a downtrend to an uptrend over the coming months.
A non-consensus view
Our current broad asset allocation views are therefore non-consensus: we like risk assets, especially global equities. We think emerging markets and Far East ex-Japan equities could do well as expectations for global trade improve. Equities in Japan and the UK are particularly attractive on valuation grounds. Sectors we like are energy, materials, and industrials, reflecting our anticipation of a global upturn in economic output and prices. Energy production is expanding at a rapid rate in North America, with the US presently the world’s largest oil and gas producer.
We do not find all equity sectors equally attractive, however. Less attractive are counter-cyclical sectors, which are less influenced by broad economic trends because they supply evergreen goods always in steady demand. Counter-cyclical sectors are likely to underperform, in our view. Defensive sectors such as consumer staples such as food and daily household goods, have enjoyed very strong returns since July 2018, and have run well ahead of the stock market in general. These and other counter-cyclical sectors, including utilities and telecommunications, are currently very much overvalued on historical measures, and their relative attractiveness will wane, in our view.
The US Federal Reserve, moreover, is intervening actively at present to alleviate short-term liquidity constraints, expanding its balance sheet for the first time in several years and expanding growth in narrow money supply, providing support to US loan growth and eventually to US consumer prices. In such contexts, shares in counter-cyclical sectors tend to underperform their pro-cyclical counterparts.
Overall, the outlook for coming months is surprisingly rosy, if you look beyond the headlines and analyse the economic data in detail. Here’s to a Happy New Year!