Lessons from 2017

Lesson #1 – the madness of crowds

The multiplying frenzy surrounding bitcoin is being fed by little more than price momentum. There has been no commensurate (or even perceptible) change in the fundamental prospects of the crypto-currency this year. We continue to argue that unless bitcoin finds itself a role in the global economy, its intrinsic value is essentially zero. We still see this role as elusive, and see the arguments behind the idea of a future ‘bitcoin standard’, as economically illiterate. However, fear of missing out can be a powerful force in investments when market values move as fast and as far as bitcoin’s has in the last several years. Bitcoin does not yet fulfil any of the criteria that we would look for in an investible asset and we would continue to advise extreme caution. Most boxes on the bubble checklist are already ticked, now all we await is a catalyst to spur the rout. This melee also serves to provide contrast to the other areas of the world’s capital markets that are apparently in bubble territory. Bonds are expensive, but we still expect most to be paid back at par. Meanwhile equity market valuations are also above long term averages, but with perhaps greater justification than is generally realised. Neither asset classes fit the description nor feel of a bubble.

Lesson #2 – Politics (still) doesn’t always matter

This was another year in which political bark and bite didn’t match up. The themes that dominated many outlook documents at the start of the year were protectionism, populism and the end of globalisation. French elections were seen as just another staging post in the inexorable return of nativist politics. Europe and emerging markets were generally seen as no-go zones by many investors as a result. In the event, European and Asian emerging market equities have been two of the stellar performers of the year so far. A sharp cyclical pick-up in global trade has been an important input into that story. Ironically, this pick-up is in large part down to the strength of US consumption, where trends in global trade tend to be forged. None of this is to argue that politics can’t be influential. However, we need to be wary of the priority many seem to routinely give to political events with regard to investment returns. We are not political strategists and cannot pretend to be able to be able to scent the changes in socio-political direction quicker or better than anyone else. The work that we have done over the last few years has instead focused on the constitutional restraints – what and how much could a particular protagonist, or group of protagonists, actually do within the confines of the various constitutions if they did make it into office? For the most part, our (admittedly guarded) faith in these restraints, alongside a degree of economic self-interest, continues to be rewarded.

Lesson #3 – The difficulties of forecasting inflation

We’ve long argued that the relationship between growth and inflation is a loose one, an idea that this year has served to reinforce. Growth has accelerated, unemployment in the developed world is close to three-decade lows, and yet still wages remain muted and the wider forces of inflation in abeyance. For our part, we do continue to see those forces slowly gathering in coming years, amidst that diminishing economic headroom. However, it remains very difficult to pin down precisely how much slack remains; from poor and incomplete labour market data to the difficulties inherent in measuring productivity in the modern, services dominated, world, it is easy to understand why an accurate estimation of output gaps eludes even the planet’s greatest minds. What we can say is that there is probably less slack than there was a year ago, and if the world economy continues on its current trajectory, the same will be true of next year. All this is important, as the main risk to our still benign outlook for markets is a sharper than currently forecast inflation pickup. We do not want central bankers hurried as they try to delicately untangle themselves from the extreme, and successful, monetary experiments of the post-crisis period.

Investment Conclusion

These are obviously not the only lessons to be learnt this year; markets are always teaching us humility for one thing. However, these three are likely to be helpful for us all to remember as we go into another year with a crowded political calendar and a few more grey hairs.

Japan — Q4 Update

Top performer

As 2017 draws to a close, most risk assets have outperformed year-to-date amidst the best global economic backdrop we’ve seen in years. The Japanese stock market stands out as one of the star outperformers, having returned 22% year-to-date against the MSCI World’s return of 19%. In this week’s In Focus, we explain in detail some of the tailwinds for Japanese outperformance, and how Japan fits into our current regional equity allocation.

Economic momentum

With 60% of revenues derived domestically, one major tailwind for Japanese stocks has been the health of the domestic economy. Japan is currently enjoying its second longest period of expansion in post-war history, with Q3 GDP growth printing at 1.7% y/y, above what most experts deem to be trend growth. Initially, the upturn was driven by broad-based export demand from key trading partners like China and the US. However, there is now growing evidence that domestic demand is also finally gaining traction. Domestic business confidence has risen to its highest level since 1991, mirrored by measures of consumer confidence. The latter speaks to improving income and employment conditions with the unemployment rate falling to a 23-year low of 2.8% and the jobs-to-applicants ratio nearing all time highs. This, in turn, is helping to drive consumer spending.

Meanwhile, both fiscal and monetary policies have been, and are expected to remain, supportive of growth. The ruling coalition’s solid victory in the October parliamentary elections has given Prime Minister Abe the go-ahead to proceed with a new ¥2 trillion supplementary budget. While the last supplementary budget centred on infrastructure investments and disaster relief, the next is likely to be focused more on populist measures such as educational support for lower income households and increased healthcare spending on Japan’s rapidly ageing populace. Moreover, the Abe administration is mulling corporate tax incentives in order to encourage firms to boost wages and productivity-enhancing capex. These fiscal plans are expansionary in nature, and should, at the margin, provide an additional boost to growth on implementation.

On the monetary side, while Japan has managed to pull itself out of sustained deflation, core inflation remains well below the Bank of Japan’s 2% target. Therefore, we see no change to the Bank of Japan’s accommodative stance as we move into 2018.

The outlook for Japanese growth remains positive looking into 2018. To us, the Japanese economy is likely to continue to benefit from robust domestic demand, expansionary fiscal and monetary policies, as well as further external demand from major trading partners.

Rising profitability

The positive economic backdrop – both domestically and externally – has coincided with improving corporate profitability for Japanese companies. Corporate profits have rebounded strongly from the 2016 downturn, and are at post-Crisis highs. As expected, the pro-cyclical sectors like technology and industrials have led the earnings charge, while the low yield environment has ensured that the financial sector has lagged. Dividend payout ratios have also risen substantially – a nascent sign that government reforms to alter corporate behaviour and improve shareholder returns may be starting to bear fruit.

Structurally, the Japanese equity market is highly pro-cyclical, with consumer discretionary, industrials and technology stocks making up more than half the market capitalisation. The corollary is that earnings leverage to improving economic conditions is strong, compared with other markets. Our outlook for continued domestic economic expansion and a supportive external backdrop heralds further upside for aggregate profitability over the medium term.

Investment conclusion

Japan’s outperformance this year hinged on some of the common macro themes we’ve witnessed in global equity markets this year – a robust domestic backdrop, strong external demand, and rebounding corporate profitability. Based on our preferred lead indicators, we think that global growth and trade momentum should be sustained as we move into 2018 – a net positive for the more cyclically-levered Japanese equity market. All of this argues for investors to have some, primarily hedged, exposure to Japanese equities. However, for the moment, we retain larger relative positions in Continental European and US equities, where we still have higher conviction in the path of corporate profitability.