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Quarterly Outlook: Are equities immune to a slowdown? — #SaxoStrats
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By Peter Garnry
It was another good quarter for global equities, with Chinese and emerging-market stocks gaining the most, followed by European shares driven by capital inflows. Investors regained confidence in Europe as the centrist, market-friendly Emmanuel Macron won solidly in the French presidential election in May.
Following that win, his party swept to a second victory in the legislative election in June, giving him the strongest mandate to reform French society of any president since the Second World War.
Some cracks finally emerged in the bull market, with Australian and Brazilian equities losing, though not by much. But it could be a warning of a pending China slowdown driven by a weaker credit impulse…
Across sectors, the biggest surprises have been utilities and real estate driven by lower long-term interest rates as the market is not buying into the US Federal Reserve’s projections. A slower trajectory for interest rates is obviously positive for the sectors utilising the most debt. The energy sector was yet again the only sector with a negative return. We have been negative on energy for three quarters now and remain negative going into the third quarter. Valuations of energy stocks still reflect excessively high expectations for a recovery in oil prices.
With the technology sector up 18% year-to-date, everyone is talking about a bubble, and June brought a reminder of volatility when the Nasdaq 100 index suddenly dropped 4% over two sessions. However, the sector quickly attracted new bids as it remains one of the few pockets of growth in the current macroeconomic environment.
Valuations on tech stocks, however, are getting stretched, and we believe the multiples expansion will not continue.
If our third-quarter slowdown expectation is right, then healthcare, consumer staples, and utilities will likely be the best-performing sectors in Q3.
Credit impulse points to lower growth
Our slowdown theme revolves around credit, which is crucial to the modern economy. Increasing evidence shows that the credit impulse, or the 12-month change in net new credit to the economy, leads one to two quarters ahead on growth. To get a sense of why credit is important, take a look at China: before the financial crisis, net new credit as a percentage of GDP was 19%, whereas the average after the financial crisis has been 29%.
The global credit impulse turned negative in the second quarter, starting with China in March. As a consequence, Q2 presented a more mixed macroeconomic picture, and recent inflation has disappointed.
Again, to understand China’s role in the global economy consider that the country is expected to contribute around 35% of global GDP growth over the next three years. With a slowing China, we expect emerging-market equities to finally underperform and the materials sector to be put under pressure.
The credit impulse is also negative in the US, and so a slowdown in Q3 would not be a big surprise. With the US economy expected to contribute 18% of global GDP growth over the next three years, the credit slowdown is obviously important for the global economy.
India, which is expected to be the third-largest contributor to global GDP growth by 2020, is also experiencing negative credit growth. The only big region with a positive credit impulse is Europe, and we remain positive on European equities as we expect capital inflows to continue.
Is Abenomics working?
The sun seems finally to be rising over Japan again, as we alluded to in a research note published in May. Japan’s nominal GDP is now above the previous peak from 1997, and its annualised growth since Q4 2012 is 2.1%, significantly above the country’s funding cost which is a key indicator for long-term sustainability.
Growth in Japan has not been this high since 1993-98. Unemployment was 2.8% in April, the lowest rate since 1994 and getting close to levels where inflation has historically picked up. If that happens, it will be one of the biggest stories of 2018. Meanwhile, Japanese equities are valued at a 20% discount to US stocks.
As a result of improving macroeconomic data and equity valuations, we are overweight Japanese equities.
The EV transformation
The year 1990 was an inflection point for personal computers and software as Microsoft crossed the $1 billion threshold in revenue. For this fiscal year, the company is expected to have revenues of $96 billion. That is a 19% compounded growth rate over 26 years.
The year 2013 was likely the inflection point for electrical vehicles as Tesla crossed the $2 billion revenue mark. Four years later there are still many sceptics, but the evidence is clear: we are already living a “Microsoft moment” in EV and autonomous driving.
According to industry estimates, long-range EV will cost around $22,000 in current USD, making them affordable even in EM countries. Estimates from Bloomberg New Energy Finance show that 35% of all global new vehicle sales are EV. That estimate could easily prove too low. If anyone is in doubt about the commitment of car manufacturers, just talk to Volkswagen. The company is planning its strategy around EV and promises 20 new models by 2020.
Source: Bloomberg New Energy Finance
The big question is how much future oil demand will be affected by EV and autonomous driving. The trends will likely reduce car ownership to the select few (like private horses for the rich), and gasoline consumption will plunge. If the current growth rate in EV continues, then by 2023 EV will displace oil demand by 2 million barrels a day, almost equivalent to the 2014 oil glut.
In other words, the EV revolution will likely cause a major crisis in the oil industry. Maybe the oil lying deep in the oceans will never be extracted?
But the biggest joker in the deck is autonomous driving, which could cut the number of cars significantly but also optimise gasoline consumption and thereby cause an even faster decay in oil demand. Taking a very long-term view, we are negative on the oil industry, and we estimate that capital in this industry will provide low returns for shareholders.