In this benign environment markets continued to make hay, with equity indices on both sides of the Atlantic setting new highs. This confounded one of my predictions for 2017 which was that the ongoing equity rally would peter out in the spring. Many measures of equity valuation certainly appear elevated: Robert Shiller’s long-term trailing P/E measure for the S&P500 is currently at the level seen at the time of the 1929 Wall Street crash and is only exceeded by the levels of the late-1990s tech boom (chart). A measure of the S&P market cap relative to US GDP is also running at levels which in the past have preceded a bust. Add in the fact that measures of market risk, as proxied by option volatility, have touched record lows in the course of 2017, suggest that this is a market which looks too frothy.
That said, solid growth and low inflation add up to a
goldilocks scenario for most investors, particularly with central banks
continuing to offer cheap money. But if we think about equity P/E ratios, the denominator (earnings) is currently not being driven by rapid price inflation: Corporate profits generally reflect the solid growth picture. Investors are thus prepared
to pay a sizeable premium for equities, which is normal in a low inflation environment.
Thus, a focus on elevated P/E ratios may paint an overly pessimistic market
view. This does not mean we can afford to be complacent and I will look at the
2018 outlook in my next post, but given the macro and monetary policy backdrop,
we can at least rationalise market movements in 2017.
Indeed, markets have shrugged off the biggest risk identified 12 months ago: politics. In that sense, one of my 2017 predictions was borne out when I wrote in early January that “I would be surprised if Donald Trump can do much damage to the US economy in 2017.” To my surprise, the administration did manage to force through its planned tax reform before year-end, with the proposed cuts in corporate taxes giving equity markets a boost. Refinements to the package suggest that the longer-term economic impacts may not be quite as bad as initially expected, with analysis by the Tax Policy Center pointing to a short-term GDP boost and a smaller rise in the deficit over the longer-term compared to the analysis it produced in June.
On this side of the Atlantic, fears that the populist surge unfolding elsewhere would find renewed expression in the Dutch and French elections proved unfounded. Indeed, the emergence of Emmanuel Macron was one of the biggest political surprises, and a positive one at that, with Europe at last finding a charismatic centrist politician committed to the liberal democratic ideas which have underpinned the peace and prosperity of the last 70 years. But the German election did provide an upset as voters deserted the two main parties in favour of smaller groups, with the AfD emerging as a relative winner. The fact that Germany has not yet managed to form a coalition government more than three months after the election is an indication that Europe’s largest economy is not without its own political problems, and the general consensus is that Angela Merkel has entered the twilight of her political career. The fact that the twin motors of the EU project continue to run out of synch suggests that the EU reform process may not make much headway in the near term.
Which brings us to Brexit, a subject that has taken up so much of my time in recent years. I assigned a 45% probability to the likelihood that the UK government would trigger Article 50 in March without making any contingency plans in the event that discussions with the EU proved more difficult than expected. But in effect, that is precisely what happened. The UK remains a divided and polarised country characterised by an absence of effective government. On Friday, Andrew Adonis, a Labour politician who chaired the national infrastructure commission, resigned citing the dysfunction at the heart of government and accused the prime minister of being “the voice of UKIP”.
To quote Adonis, “I do not think there has ever been a period when the civil service has been more disaffected with the government it serves. I do not know a single senior civil servant who thinks that Brexit is the right policy, and those that are responsible for negotiating it are in a desperate and constant argument with the government over the need to minimise the damage done by the prime minister’s hard-Brexit stance. It is an open secret that no one will go and work in David Davis’s department, and Liam Fox is regarded as a semi-lunatic.”
Whatever one’s views on Brexit, Adonis’ comments highlight what many of us have suspected for a long time: The government does not have a plan, without which Brexit will be an utter car crash. And to think, the Conservatives remain the largest party in parliament (despite losing their majority following a spectacularly incompetent election campaign). What does that say about the opposition? Or indeed us? We deserve better in 2018.
Indeed, markets have shrugged off the biggest risk identified 12 months ago: politics. In that sense, one of my 2017 predictions was borne out when I wrote in early January that “I would be surprised if Donald Trump can do much damage to the US economy in 2017.” To my surprise, the administration did manage to force through its planned tax reform before year-end, with the proposed cuts in corporate taxes giving equity markets a boost. Refinements to the package suggest that the longer-term economic impacts may not be quite as bad as initially expected, with analysis by the Tax Policy Center pointing to a short-term GDP boost and a smaller rise in the deficit over the longer-term compared to the analysis it produced in June.
On this side of the Atlantic, fears that the populist surge unfolding elsewhere would find renewed expression in the Dutch and French elections proved unfounded. Indeed, the emergence of Emmanuel Macron was one of the biggest political surprises, and a positive one at that, with Europe at last finding a charismatic centrist politician committed to the liberal democratic ideas which have underpinned the peace and prosperity of the last 70 years. But the German election did provide an upset as voters deserted the two main parties in favour of smaller groups, with the AfD emerging as a relative winner. The fact that Germany has not yet managed to form a coalition government more than three months after the election is an indication that Europe’s largest economy is not without its own political problems, and the general consensus is that Angela Merkel has entered the twilight of her political career. The fact that the twin motors of the EU project continue to run out of synch suggests that the EU reform process may not make much headway in the near term.
Which brings us to Brexit, a subject that has taken up so much of my time in recent years. I assigned a 45% probability to the likelihood that the UK government would trigger Article 50 in March without making any contingency plans in the event that discussions with the EU proved more difficult than expected. But in effect, that is precisely what happened. The UK remains a divided and polarised country characterised by an absence of effective government. On Friday, Andrew Adonis, a Labour politician who chaired the national infrastructure commission, resigned citing the dysfunction at the heart of government and accused the prime minister of being “the voice of UKIP”.
To quote Adonis, “I do not think there has ever been a period when the civil service has been more disaffected with the government it serves. I do not know a single senior civil servant who thinks that Brexit is the right policy, and those that are responsible for negotiating it are in a desperate and constant argument with the government over the need to minimise the damage done by the prime minister’s hard-Brexit stance. It is an open secret that no one will go and work in David Davis’s department, and Liam Fox is regarded as a semi-lunatic.”
Whatever one’s views on Brexit, Adonis’ comments highlight what many of us have suspected for a long time: The government does not have a plan, without which Brexit will be an utter car crash. And to think, the Conservatives remain the largest party in parliament (despite losing their majority following a spectacularly incompetent election campaign). What does that say about the opposition? Or indeed us? We deserve better in 2018.
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