SINGAPORE (Feb 12): It appears increasingly obvious that the traditional business cycle is returning after more than a decade of quantitative easing across developed markets, says Neo Teng Hwee, chief investment officer and head of investment products and solutions at UOB Private Bank. The business cycle — that is, the ebb and flow of economic growth that occurs over time — was disrupted by the global financial crisis, and then the QE years as central banks experimented with ways to propel economies out of recession. This expansion which started in 2009, will be the longest on record if it continues to 2019, Neo says.
Last year was the first time in a long while that economists started the year on a sombre note and revised growth upwards continually. “For the last couple of years, we started the year fairly positive and growth was revised downwards through the year; 2017 was quite an exception. Growth got revised higher,” Neo points out.
What is the outlook for companies and equity markets now that the traditional business cycle is upon us?
“One of the most important items to consider is sources of growth. Finally, businesses are starting to invest. Capital expenditure (excluding investment into residential property) is starting to recover,” Neo says. A recovery in the business cycle is always positively correlated with growth in capex by companies.
The Fed, growth, inflation
A typical business cycle starts with the economy expanding. Then, it runs out of capacity, inflation starts to pick up, central banks need to hike rates and contraction sets in, setting the scene for the next recession. “Sometimes, when you have an oil shock or a real estate bubble, it tends to deepen the recession, which is what happened in 2008,” Neo says.
To recap: The US Federal Reserve started a rate hike cycle in 2004, which ended with the subprime crisis and global financial crisis (GFC) in 2008. “We had a period of rate hikes. At the same time, we had a massive property bubble, exacerbated by subprime lending. That, and excesses in the system, deepened the downturn,” Neo says.
In his view, the Fed is always the key player. Since 2008, recovery has been anaemic and, although the length of expansion is quite remarkable, growth has been meagre. “Looking at the length of an expansion in itself doesn’t tell the whole story. You have to look at the cumulative magnitude of the expansion. This expansion has been very long, but it has been very weak,” Neo says. In effect, US and global growth has been underperforming previous episodes of expansion. “To say that we have expanded and gone to an overheating stage is not true.”
European growth to quicken
Interestingly, Neo and economists in general believe European growth will continue to quicken. “Europe is one area that is very positive and I would say European growth is more powerful than [that of] the US,” Neo says. This is because the European debt crisis that followed the GFC was deep, unemployment was high and austerism (economic theory that austerity cures a recession) caused growth to collapse. Once austerity did not work, the European Central Bank (ECB) started its version of QE. Only now are countries such as Portugal, Italy, Greece and Spain — the PIGS — rebounding. In addition, Europe has had a series of elections in countries such as the Netherlands, France and Germany, where populism’s hand was stayed.
Now, the economic upswing that started modestly is beginning to take hold almost everywhere, including in places such as Brazil and Russia, where very high interest rates — to support their weak currencies — are beginning to fall.
In Singapore, growth quickened last year. Manufacturing rebounded, the property market has firmed up, and even the debilitated oil and gas sector has stabilised.
Not a Goldilocks economy
So far this decade, inflation has been remarkably benign, even though unemployment in the US has fallen to its lowest level this century. “A puzzle in the system is unemployment (4.1%). Historically, this would have been associated with inflation tracking 2% to 3%, but the PCE deflator is tracking 1.4%,” Neo observes. The PCE deflator is the personal consumption expenditure index, and an indication of inflation that is constantly monitored by the Fed.
This is probably because wage growth has been very slow despite a tight labour market. Some observers believe this is due to structural changes in the economy. In a nutshell, the economy is moving in a new direction with digitalisation, artificial intelligence and robotics, and skills development has not kept pace. Labour participation continues to fall, and part-time employment remains elevated. “We’re so far in the cycle and labour participation hasn’t picked up. That means the unemployment is structural,” Neo says. “Workers may not be equipped to participate in these new sectors.”
Growth with little or no inflation is seen as the perfect environment — a Goldilocks economy, where central banks can run an easy policy. Unfortunately, it appears that if the usual business cycle resumes, inflation will start to rise. And, if inflation exceeds the Fed’s 2% target, that might be an issue for financial markets, Neo cautions. The Fed has guided for three rate hikes this year, with the first scheduled in March.
Elsewhere, with quickening European growth, ECB could be underestimating its potential to taper QE and set the stage for higher interest rates. “There’s simply not enough bonds for them to buy. If you look at the amount of bonds they’ve been buying on an annualised basis, it’s about seven times more than the amount of bonds that have been issued. Tapering is going to happen pretty soon,” Neo says. “We are past peak liquidity where QE is concerned.”
QE provided the liquidity that drove asset prices higher. Neo points out, however, that equity prices also rose because of earnings growth. “It wasn’t all about liquidity. There was also a real earnings recovery, and going past peak liquidity is not going to be a constraint on growth.” Moreover, credit creation was a lot less than expected during the QE years. Velocity of money did not rise, and the liquidity did not lead to excessive borrowing. “So, when you withdraw this central bank liquidity, it does not mean this credit is going to shrink by the same magnitude,” Neo says.
What happens to stocks?
There is a very close correlation between the level of interest rates, inflation and fair market valuation. For the US, if inflation continues to stay at 1% to 2.5%, its current price-to-earnings ratio of 19 times could be sustained provided inflation does not rise.
Inflation is key because it drives central bank normalisation and the pace of normalisation drives market perception of what is a fair PER number. If the 10-year treasury yield stays under 3%, it should not be a problem to sustain PER, Neo explains. “For 2018, the key metric to look at is inflation, inflation and inflation.”
Net margin profit percentiles
The circular chart indicates net margins of companies in the various markets from the previous peak in 2007, year-ago margins and the most recent margins. Red represents the last cycle peak, light blue is the valuation in 2016 and dark blue is where it stood in 2017.
Based on this chart, some countries such as the US are very close to the last cycle peak. This implies that there is less room for profit margins to expand. On the other hand, emerging-market margins are way below their previous cycle peak. The markets in which profit margins have the potential to rise are Asia ex-Japan, Italy and the UK.
Neo Teng Hwee, chief investment officer, UOB Private Bank, says: “If we’re going to see further economic recovery, we should see earnings trending back to the last cycle peak. It means there is room for margin expansion. We are somewhat positive on Japan. We think its margins could exceed that of the last cycle peak. Europe has some room to improve.”
