Economic Outlook for October
It is often stated that “stock markets do not group in a straight line” but this year global equities seem to contradict this notion. During September most major equity indices recorded favourable performances again: in the US the S&P 500 index advanced by 1.7% whilst the Euro Stoxx 50 jumped by 4.4% (although the FTSE showed a modest decline). The performance in Asia was mixed with the Nikkei 225 rising by 3.3% but the Hang-Seng Index dropping by 1.4%.
The recent out-performance of European markets reflects improving economic trends and increased political stability, enabling European equities to catch up somewhat with the bull market across the Atlantic. During the third quarter the Dow Jones index recorded an impressive advance of 5%; this adds up to eight quarterly gains in a row (the S&P 500 rose nearly 4% and the Nasdaq by 6 %).
So, where do markets go from here? A pullback cannot be ruled out but within a background of globally synchronized growth, combined with a pedestrian pace of interest normalization, the outlook for the fourth quarter is favourable. Global equities’ valuations are still within historic ranges although many commentators currently view the US equity market as relatively expensive. US Valuation multiples improve dramatically, however, if the proposed tax reforms were to be incorporated in the calculations.
What is “interest rate normalization”?
Central banks in mature economies have either initiated (the US FED) or are gearing up (ECB) to eliminate crisis-era monetary measures and normalize interest rates in the process. This policy stance has recently been complicated by persistent low inflation and the fact that central bankers aim at 2% inflation. Press releases by central banks keep stressing that the current under-shooting of consumer prices inflation is temporary and they express confidence that their targets will be met. Judging by contradictory statements of members of the rate-setting Federal Open Market Committee (FOMC) at the FED one must conclude that doubts are emerging regarding the temporary nature of subdued inflation.
A structural reason for low inflation at a global scale could be the accelerating application of new technologies that put price pressure on consumer goods (mostly through the high growth in Ecommerce). Some commentators are suggesting that a low inflation environment should not lead to a postponement of the normalization process but this raises the question what the level of normal interest rate should be. In other words, how much tightening of central banks can we expect?
A recent paper (by Carvalho, Ferrero, and Nechio at the Federal Reserve Bank of San Francisco), titled Demographic Transition and Low U.S. Interest Rates, adds an interesting structural argument of why market interest rates could stay low by historic standards. They observe that interest rates have actually been coming down for more than twenty years in the USA. They suggest that this could be explained by demographic trends: with people living longer and population growth rates declining there is an increased incentive to save which, in turn, exerts downward pressure on (real) interest rates. Also, GDP growth is influenced by population growth and a reduction in population growth reduces productivity growth thereby pushing interest rates down as well. As demographic trends are structural, this phenomenon could keep interest rates low for a considerable period.
Fiscal policies moving into focus
The very gradual pace of interest rate normalization suggest that monetary polices are likely to lose their prominent place in the minds of equity traders and cease to be a major factor in driving investors’ sentiment. The elimination of monetary stimulus, ten years after the global financial crisis, would be an important factor in assessing global trends. Incoming global economic data, as well as leading indicators such as PMIs, indicate that the global economic growth momentum does not require any further crisis-era emergency measures.
As the influence of monetary policy seems to be gradually fading, policy makers are increasingly focusing on structural economic reforms and fiscal policies. For instance, the French president has introduced labour market reform legislation, the Italian banking system is being restructured, and in the German government negotiations the finance ministry will likely end up in the hands of the pro-business FDP (which means that tax reforms might be possible).
The most spectacular reform proposals are obviously coming from the USA government with the publication of the long-awaited tax reform outline. The proposed measures have structural elements but will also stimulate the economy in the short term. Any economic stimulation would arrive at a moment that the US economy is growing at its fastest potential rate in more than two years (second quarter GDP growth was recently upgraded to 3.1%) and labour markets continue to improve. Although probably too early to asses, the US tax reforms do have the potential to over-heat the economy.
A closer look at the stock market implications of the tax reform proposals illustrates the significant impact these measures can have. The reduction in the corporation tax from 35% to 20% represents a crucial component of the reforms for equity investors. A simple calculation of the effects on corporate earnings and the overall valuation of US equities highlights its importance: reducing the corporation tax from 35% to 20% boosts net profits by 23%. This represents of-course a one-off boost although government officials claim that it will add to long-term growth prospects as well. This earnings boost implies that the valuation of US equities, as expressed by the market Price to Earnings (P/E) would “shift down” post the implementation of the lower tax rate. According to Yardeni Research the forward looking P/E ratio for the S&P 500 is 17.7 times at the moment; applying a 23% earnings boost the P/E ratio would be 14.4 times which compares with a long term average P/E of around 16 times and would represent “good value”. From this straightforward calculation one can conclude that equity investors have not fully incorporated the tax reforms in the valuations. This can be explained by skepticism regarding the government’s ability to implement the tax measures as well as the lack of clarity regarding the timing of their potential introduction.