Reflecting on a turbulent past

Not only is the last day of the year but it is also the end of a long and troubled decade and as usual at this time of year I want to spend a little time looking back. Looking first at 2019, how did I do in terms of my big calls?

2019 in review

In terms of the economics, I did broadly OK, arguing at the start of the year that “it is unlikely that we will see recessions in any of the world’s major economies this year.” That said, it was a bit touch-and-go in Germany for a while and the euro zone economy slowed by more than I anticipated, largely because the US-China trade dispute caused more damage to Europe than expected. Indeed, the global economy felt a bit softer than we had hoped, partly due to trade issues but perhaps because the economic expansion in place for the last decade is long in the tooth.

Whilst I was overly optimistic on the economy, I vastly underestimated the markets’ capacity to defy gravity. We have seen double digit rates of return across the equity space, with key US markets up by more than 25% year-to-date although over a two-year horizon, the gain is only around 20% (chart). I could kick myself for missing out on that opportunity but I’d probably miss! Monetary policy was the driving force here, with Fed rate cuts that were not foreseen at the start of the year giving markets a shot in the arm. Although I hold to my view that equity markets are overvalued, increasingly we cannot look at individual asset markets in isolation. Investors continue to pile into equities because the alternatives are dire. When large parts of the fixed income universe are yielding negative returns, there is every incentive to chase the higher dividend yields generated by equities – not to mention the prospect of a decent capital gain.

As for politics, I was right in predicting that the UK would not leave the EU without a deal, but that was a long and tortuous process that nobody wants to repeat. But I was wrong in suggesting that “impeachment proceedings will not be initiated against Trump”. Clearly the Democrats believe that the political calculus has changed and that it is worth their while to follow through, even though their chances of removing President Trump from office appear slim. And finally in terms of my 2019 predictions, I did not see the emergence of Christine Lagarde as ECB President, but I was glad to see that the BoE did indeed “look no further than FCA Chief Executive Andrew Bailey” in finding a successor to Mark Carney.

The 2010s in context

This being the last day of the decade, it is worthwhile examining how far we have travelled in the past 10 years. At the end of 2009 we were coming off the back of the biggest peacetime economic collapse in 80 years. The outlook for the year ahead was not especially bright but the general belief was that within a few years growth would recover to pre-crisis trends and that monetary policy would slowly normalise. Neither of these things has happened in Europe.

Although European politicians are reluctant to admit it, we are experiencing a form of Japanification. One of the defining features of the post-bubble Japanese economy was that the slowdown in population growth occurred at the same time as policy makers were struggling to cope with the after-effects of the bubble. This meant that they did not notice the slowdown in trend growth until it was too late. In Europe, baby boomers have retired in droves over the past decade, with the result that the contribution to potential growth from labour has diminished and in the absence of a boost from capital investment, European potential growth is now much slower than before the financial crisis.

However, this does not justify holding interest rates near zero for so long (let alone in negative territory as the ECB has done). I maintain, as I have done for a long time, that the costs of this policy will ultimately outweigh the benefits (if they haven't already). Over the next decade, we will feel the costs in terms of our nugatory pensions. And I continue to wonder whether part of the reason for weak investment activity is because low interest rates mean low rates of financial return.

But the biggest change over the past decade has been in the political field. Nationalism is the order of the day in many parts of the world and finds its most obvious expression in the form of Trump and Brexit but it is bubbling away across Europe and Asia. A decade ago, Barack Obama was the cool president for a new America but in less than a decade he was replaced by an angry populist with plenty to say but no clear policy ideas. Similarly, Grexit was starting to rise up the worry list a decade ago but it is the UK which is about to leave the EU.

As I have noted before, both these issues reflect the failure of centrist politics. Politicians overpromised and under-delivered in the wake of the crash but electorates now want leaders who will take action rather than offering jam to tomorrow. Unfortunately the issues we face are more complex than politicians are prepared to admit in public. Demographics are changing the face of European economies and will force politicians to take some hard choices when it comes to allocating resources. The rise of China has also changed the political calculus in the US and Europe and will continue to shape world events in the 2020s.

If you have read this far, however, thanks for sticking with it and congratulations on surviving another year - indeed another decade. I wish you all a peaceful and prosperous New Year.

2018 in review

As we look back at 2018, many of the bigger trends which I anticipated a year ago did indeed pan out. There were a few unanticipated surprises, of course: It would not be quite the same if there were not. To summarise the year as succinctly as possible, global growth held up although fears of a slowdown began to materialise late in the year; markets had a rocky year and politics dominated the agenda. 

As I noted in early January, markets at the start of the year were entering late-cycle territory with many investors describing themselves as “reluctant bulls.” My recommendation at the start of the year was to reduce the degree of risk exposure, primarily because I expected volatility to pick up, but I still expected equity markets to end the year up 5-10%. I was right about the volatility but wrong about the trend in equities, although I was right to believe that equities could not continue to rally as they had done in previous years. The equity option volatility trend reflects a change in investor attitude towards risk and there was a sharp spike in February and a less elevated but still strong upward movement towards the end of the year. I have long believed that markets were under-pricing risk and 2018 was the year that a reassessment took place. Many of those who were reluctant bulls a year ago are now outright bears, and with hindsight I should have had the courage of my convictions to call for the market correction that I feared might happen.

The reasons for the investor reassessment are many and varied. My main concern a year ago was I believed equities to be overvalued: Based on the Shiller ten-year trailing P/E metric I still believe they are. Cracks in the tech universe were another factor: Tech stocks continued to fly high until late in the year but I did warn that “a market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.” And so it proved when the FAANG stocks started to give up their gains around October. This is partly the result of product dependency fears, with concerns that demand for Apple products is slowing, and cyclical factors as growth concerns mount. I also noted that the Fed’s quantitative tightening policy, whereby it continued to reduce its balance sheet, at a time when interest rates were rising indicated that “more air is being taken out of the monetary balloon than at any time in the past decade.” There is no doubt that US monetary support for equity markets has been steadily withdrawn over the past 12 months.

But undoubtedly the biggest factor influencing markets was the outbreak of a trade war between the US and China – something which happened more suddenly than I anticipated because I thought that President Trump’s bark was worse than his bite. Although the G20 summit in December appeared to take some heat out of the US-China trade dispute, many of the issues which prompted the dispute in the first place remain unresolved. In what appears to have been a truce in trade hostilities, China made some trade concessions that prompted the US to hold off from raising tariffs on a wider range of goods. But China continues to skirt around the fact that the expropriation of copyright technology as a precondition for foreign firms to do business in the domestic Chinese market remains a live issue. To the extent that the trade ceasefire is conditional on eliminating this problem, we cannot say that trade concerns will not resurface in 2019.

Perhaps one of the biggest issues exposed by the trade war is that the rules-based architecture on which global prosperity has been based is threatened in a way we have not seen in many decades. The WTO exists as part of the institutional framework to prevent trade frictions from escalating, with 38 disputes brought before it this year alone. Unfortunately, the Trump administration is sceptical that the WTO will act in favour of the US and it continues to block appointments to the WTO’s Appellate Body which has been reduced from seven members to three. With the terms of two members set to expire in December 2019, this would reduce the Appellate Body below its necessary quorum unless new members are appointed and would mean that the WTO is no longer able to arbitrate in trade disputes. For the record, an analysis of WTO cases brought against China[1] indicate that “there are no cases where China has simply ignored rulings against it” – in contrast to the US which “has not complied with the WTO ruling in the cotton subsidies complaint brought by Brazil.” Bias? What bias?

But it is not only trade issues that have rattled markets. There is a growing trend towards economic nationalism evident throughout global politics which is leading to concerns that we have passed the high water mark of globalisation. Trump’s America First policy is a clear manifestation of this, as is Brexit. Indeed, perhaps one of the key trends to emerge in 2018 was the sense of drift in political leadership. I have talked at length about the political failures of Brexit, and I have serious reservations that politicians will see the light in the next three months which will avoid a hard Brexit having spent the past 30 months behaving irrationally. But French and German politicians are also facing increased pressure from an electorate which does not like what is on offer, whilst Italy’s populist policies have drawn the ire of the European Commission. This lack of leadership and inability to rise above local concerns to see the bigger picture is one of the biggest threats to the economy and markets as we look ahead to 2019.

In terms of some of my other 2018 predictions, I didn’t do altogether badly. Bitcoin prices collapsed, as I suspected they would; there was no war on the Korean peninsula and Donald Trump was not impeached. I was also right that Italy would not win the World Cup (though that was more to do with the fact they did not qualify for the finals). But when I did do the analysis in mid-year and tipped Germany to win, I did so only on the basis that the 18% probability assigned to their victory chances implied an 82% they would fail to win. Those are the sort of predictions I like – ones which can be both right and wrong at the same time. Happy New Year.

[1] Bacchus et al (2018) ‘Disciplining China’s Trade Practices at the WTO’, Policy Analysis 856, Cato Institute

2017 in review

After an unpredictable 2016, 2017 was unable to live up to that level of excitement – and I for one am extremely thankful for that. From a macroeconomic perspective there were certainly no fireworks: GDP growth in most parts of the world was steady, and in Europe it outperformed expectations – even in the UK, where recent data revisions suggest a growth rate closer to 1.8% in 2017 rather than the long-predicted 1.5%. Central banks did not have a lot to do, other than the Fed which raised rates in three steps of 25 bps, although the Bank of England surprisingly stepped into the ring with a 25 bps rise in November. The lack of both wage and price inflation is becoming an increasing cause for concern in many parts of the industrialised world, although policymakers hope that ongoing recovery in 2018 will eventually prompt a pickup.

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.

That was the year that was

It has truly been a historic year, the reverberations of which will echo for years to come. Above all, 2016 was the year of politics and will primarily be remembered as the year when electorates in the west decided that enough was enough. And who can blame them? Governments have spent the past seven years trying to convince their electorates that normality is just around the corner, when in reality they should be preparing for the new normal. Conventional countercyclical policy is battling against the headwinds of globalization and rapid technological change, which add up to make this the most unsettling period that many of us have ever experienced.

The geo-political environment is in a state of flux as the tectonic plates of the post-1945 order move again. Far from this being the end of history, as Francis Fukuyama once predicted, we are closer to Yogi Berra’s aphorism that it’s déja vu all over again. Precisely at a time when strong political leadership is called for, we find it is sadly lacking.

In the UK David Cameron – a deeply flawed leader who gambled his country's economic future for short-term political gain – has been succeeded by Theresa May, who gives no public indication that she understands the complexities of negotiating Brexit. In France, President Hollande is the most disliked president in French history, to the extent that he will not stand again next year because he knows he cannot win over the people. There is indeed a non-negligible probability that the French could elect a far-right president next year in the shape of Marine Le Pen, although I would not put money on it. Italian PM Renzi quit after his proposals for constitutional reform were rejected in a referendum which ended being a plebiscite on his own term of office. Only Angela Merkel is still standing tall, but even her popularity could take a tumble in the wake of recent events, as her open borders policy is increasingly scrutinized. With an election due in the autumn, the world will be watching to see whether Germany can uphold the values of liberal democracy which are being eroded elsewhere.

Meanwhile, the political situation in the US is almost beyond parody. Although the economy has recovered more rapidly than most, Barack Obama is unlikely to go down as a great president. A great orator he may be, but he has failed to offer the leadership that the western alliance so badly needs. Whilst his policy of avoiding military entanglements was taken for sound reasons, his Middle Eastern policy has been a failure, and if anything has made a bad situation worse. His attempts to reset relationships with Russia have also been a dismal failure. Moreover, he spent a lot of time and effort battling Congress on basic economic issues such as the debt ceiling (though that is more the result of Tea Party influenced ideology than the president's stance). But as sub-standard as Obama may have been, the election of Donald Trump represents a leap into the unknown. It is a measure of the dissatisfaction which many Americans feel that they are prepared to give the keys to the Oval Office to someone who lied and exaggerated their way through the most unedifying presidential campaign in history.

Vladimir Putin and Xi Jinping can at least look forward with more optimism. Putin has restored some prestige to Russia's tarnished image, and although the economy will continue to suffer from the sanctions which are still in place, he will be taken more seriously on the global stage following Russia's intervention in Syria. China's President Xi will continue to preside over the world's most dynamic large economy as he consolidates his domestic power base. There will be difficulties ahead, however, and as both leaders look to reassert their country's position on the world stage, we will need a cool head in the White House to ensure that matters do not get out of hand. It may indeed be the year when we learn the true value of President Obama.

It is against this backdrop that the world economy will continue to operate and I will save the 2017 economic outlook for another post. What 2016 has taught us, however, is that the shape of the risk distribution has changed. Outcomes which we thought implausible are manifestly not. The good news is that there is profit in uncertainty. Apparently, the bookmakers’ joint odds that the UK would vote for Brexit; that Trump would be elected US president and that Leicester City would win the English Premier League were 4.5 million to one. Paddy Power is offering odds of 33/1 that the existence of alien life will be proven in 2017 (2016 odds are quoted at 80/1, so you have less than a day to place your bets). Meanwhile, Fergus Simpson, a mathematician at the University of Barcelona, reckons that there is a 500/1 chance of a cataclysmic event wiping out human existence in any given year during the 21st century (Don’t believe it? Go here).

Above everything else, however, we have learned not to trust bookmakers odds (a remain victory or a Clinton presidency anyone?) And as Michael Gove so memorably remarked, we have all “had enough of experts” (although only until they are proven right).