Can markets repeat the 2016-18 boom?

As global activity stabilises, risk assets have started to recover

Gavyn Davies

FILE PHOTO: The Charging Bull or Wall Street Bull is pictured in the Manhattan borough of New York City, New York, U.S., January 16, 2019. REUTERS/Carlo Allegri/File Photo
Global equities enjoyed a prolonged bull market in 2016-18 during a strong economic upswing © Reuters

Global financial markets have adopted a more positive tone in recent weeks. Equities are hitting new highs, and the yield curve in the government bond markets is beginning to correct a small part of the “inversion problem”, which I discussed last week.

In the course of the decade-long equity bull market since the global financial crisis, there have been several temporary phases of relative weakness that ended with extremely powerful surges in risk assets. These occurred, notably, in 2011-14, following the eurozone crisis, and then in 2016-18, following the China devaluation shock. This latter phase was dramatic, involving a cumulative rise in world equities of 60 per cent from February 2016 to January 2018, according to the FTSE Global All Cap Total Return Index.

There are certainly some similarities between what is happening now and the inflection point in the world economy in 2016. Is it possible that asset markets are embarking on a repeat of the euphoria seen in that period? Market psychology is always unpredictable, but it seems unlikely.

On the optimistic side, there is some tentative evidence that the contractionary forces that have hit the world economy since early 2018 are beginning to abate. The geopolitical policy shocks from Brexit and Donald Trump’s tariffs against China have clearly moved in the right direction, though it remains likely that the damage from the “entrenched uncertainty” caused by these economic policy developments could prove long lasting.

Furthermore, the Federal Reserve has fully reversed the tightening in monetary policy that was intended late last year, without necessarily shifting the stance of policy very far into accommodative territory. Monetary policy in the eurozone and Japan is now, in effect, stymied but overall global financial conditions have benefited from the rise in equities and the narrowing in credit spreads seen this year. 
As a result of somewhat supportive financial conditions, economic activity data are moving broadly sideways, instead of downwards. In the manufacturing sector, which has been at the heart of the slowdown across the world, the JPMorgan global output purchasing managers’ index rose to 50.3 in October, about a point higher than three months earlier. 

Furthermore, the global capital expenditure index, calculated by the same source, seems to have bottomed out in 2019 Q3, after a sharp slowdown in the previous year.

Unfortunately, these important signs of recovery in the manufacturing sector have been offset by a weakening in services, with the services output PMI dropping by 1.5 points in October, compared with three months earlier.

The Fulcrum global nowcast, which includes data from both manufacturing and services sectors, has been broadly stable recently, indicating activity growth around 3 per cent. This stability could be consistent with a turning point for global activity (see box).

If a recovery is indeed starting, the next question is on its likely strength. During the 2016-18 upswing, growth in the global economy jumped from 2 per cent to 5 per cent, and remained above the 4 per cent trend rate for several successive quarters. However, some important features of the 2016-18 economic recovery seem unlikely to be repeated this time.

- The US economy is working much closer to full capacity, which implies that future growth is more likely to be constrained by supply shortages than during the previous upswing. Whether or not this leads to an eventual tightening in monetary policy, there seems much less scope for gross domestic product growth to exceed trend for a prolonged period.

- The last recovery benefited from the fiscal stimulus introduced by the Trump administration. According to the IMF, this amounted to 1.6 per cent of GDP over 2017-18, and the focus on corporate tax cuts clearly boosted equity prices and business confidence. This will not be repeated in the next two years. In fact, business and market concerns about the election of Elizabeth Warren as president might well have the opposite effect.

- Macro policy in China is more concerned about deleveraging in the shadow banking sector than it was after 2016. The authorities have so far successfully eased fiscal and credit policy enough to offset the contractionary effects of the US tariffs, but they do not seem interested in pushing the GDP growth rate above the 6 per cent-6.5 per cent target next year. Instead, the authorities seem likely to tolerate a weaker upswing, if this is the necessary consequence of reducing the credit/GDP ratio further.

- The 2016-18 economic rebound benefited from a period of above trend eurozone growth, triggered by a broadening of the European Central Bank’s unconventional monetary stimulus, normalisation of bank credit growth in the eurozone’s indebted economies and an easing of deflationary fears. Lately, these boosts seem to have run entirely out of steam, and the eurozone has been by far the main source of disappointment among the major economies this year. With the ECB’s policy armoury now almost entirely empty, eurozone growth is unlikely to rise strongly next year.

These arguments suggest that any rebound in global growth in 2020 may struggle to replicate the powerful momentum seen in 2016-18.

A final consideration for the market outlook is that the valuation of equities as the economic activity cycle turns upwards is more stretched than it was in 2016. According to Fulcrum’s expected returns model, US equities were priced to produce three-year ahead returns of around 10 per cent per annum in 2016, whereas they are now expected to produce returns of only 4 per cent.

With the global economy apparently avoiding a recession, equity returns next year may be adequate, but not great.

Last two economic and equities cycles compared

Global activity, measured by the Fulcrum daily nowcast series, may be tracing out a flat bottoming-out pattern, similar to that in 2015-16.

Global equities enjoyed a very prolonged bull market in 2017 as the strong economic upswing continued. However, a repeat of this strong economic recovery, and bull market, seems somewhat improbable in 2020-21.

Will China Confront a Revolution of Rising Expectations?

Amid much discussion of the challenges facing the Chinese economy, the line-up of usual suspects typically excludes the most worrying scenario of all: popular unrest. While skeptics would contend that widespread protest against the regime and its policies is unlikely, events elsewhere suggest that China is not immune.

Barry Eichengreen

eichengreen134_Ryan PyleCorbis via Getty Images_chinamanbuildinghallway

ZURICH – For over a decade, China has accounted for a quarter or more of global economic growth. With its economy currently navigating a rough patch, the question is whether this impressive performance will persist.

Cassandras pointing to the possibility of a Chinese growth slowdown regularly invoke the specter of a middle-income trap. Now that China is no longer poor, they warn, growth rates will fall, just as they have in all but a handful countries that have reached the same income level.

Growth is harder, they observe, when it can no longer be based on brute-force capital accumulation. Now, it must be based on innovation, which is difficult to bring about in an economy that is still centrally directed.

Then there is the corporate sector’s heavy debt load. A decline in earnings could render many of these debts unsustainable. Whether the upshot is cascading defaults or a flurry of bailouts that shift the burden to the government, the result would weaken the country’s finances and sap investor confidence.

On top of this is the country’s aging population, which requires shifting investment from industrial capacity to social services. This will imply slower growth insofar as productivity chronically lags in the service sector.

Finally, there is the possibility of a full-blown trade war with the United States. We currently hear much talk of a “phase one” deal between the US and China. But if we know one thing about US President Donald President Trump, it is that he is a “tariff man.”

Now facing an intensifying impeachment inquiry, he will seek to deflect attention. Like any autocrat meeting resistance at home, he will marshal support by focusing on a foreign opponent. This means that any “phase one” agreement will be at best temporary.

Missing from this line-up of usual suspects, however, is the most worrying scenario of all: popular unrest. Skeptics contend that widespread protest against the regime and its policies is unlikely. The Politburo continues to deliver improvements in living standards – and its security apparatus is formidable.

But consider events elsewhere. In France, the Yellow Vests have been protesting most immediately against higher fuel prices but more broadly against a perceived lack of economic opportunity. In Ecuador, anti-austerity protests reflect, more fundamentally, opposition to President Lenín Moreno’s government, which students, unions, and indigenous people criticize as out of touch with the public.

Protests in Chile were triggered by an increase in metro fares but have also focused on inequality, the education system, and pension problems. Closest to home, of course, is Hong Kong, where political meddling by mainland China fueled protests that now target the city’s prohibitively high housing costs.

These movements are revolutions of rising expectations. They are protests not so much over a deteriorating quality of life as over government’s failure to deliver everything that was promised.

Such protests are spontaneous, sparked by small matters, like a hike in fuel prices or metro fares. But, because those small matters are indicative of the government’s disregard and even ignorance of popular concerns, they morph into larger movements. These movements are leaderless, relying as they do on social media, which makes them hard to behead, but also causes them to evolve in unpredictable, even violent, ways.

Mainland Chinese are following developments in Hong Kong closely, at least insofar as state media and Internet censorship permit. While some see events there as an affront to their national pride, others appear to be drawing different conclusions. One recent study shows that those exposed to events in Hong Kong as a result of having visited during demonstrations are more likely to engage in online discussions of politically contentious issues.

And it is not as if Chinese people lack grievances. They complain about regional inequality, especially if they live in the impoverished west. If they farm on land abutting urban development, they are concerned about property rights. Members of the “Ant Tribe” – recent university graduates who can’t find jobs matching their academic credentials and are reduced to living in subterranean hovels – are understandably concerned about social mobility.

On top of this are broader concerns about housing prices, especially in China’s first-tier cities. Hong Kong has an extraordinarily high house-price-to-income ratio of 49. But China, with a ratio of 30, is not far behind: it ranks fifth among 95 countries for which data are available.

People similarly have concerns about the quality of health care and other social services. While China is moving rapidly up the global per capita income league tables, its ranking for infant mortality, at 122nd, remains shockingly low.

If unrest does, in fact, break out at some point in the future, foreign investors will be quick to withdraw. As capital flees to safer havens, the authorities will have to tighten capital controls. They will be forced to put their plans for financial opening and their dream of renminbi internationalization on hold.

Above all, unrest would cause GDP growth to suffer. A weakened economy would leave more expectations unmet – and raise further questions about popular support for the regime.

Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is The Populist Temptation: Economic Grievance and Political Reaction in the Modern Era.


The wars in Iraq and Afghanistan have cost most Americans nothing

That is why they continue

WHEN SERGEANT LIAM DWYER of Connecticut trod on a booby-trapped bomb in southern Afghanistan the explosion could be heard 13 miles away. It blew off his left leg, much of his right one, left his left arm “hanging by threads” and smashed his right arm. “I’m bleeding out and about to die,” he recalls thinking before he blacked out. His field-medic turned away to work on lesser casualties.

But another marine sergeant clapped tourniquets on what remained of Mr Dwyer and hauled him to a helicopter. A week later, after round-the-clock treatment by American and British medics in Afghanistan, Germany and on many aircraft, he awoke at Walter Reed National Military Medical Centre. His parents were by his bed. Thinking he was still on the battlefield, Mr Dwyer lunged forwards to try to protect them.

Eight years later he was back at Walter Reed in Bethesda, Maryland—and life was great, he told your columnist. He had some gripes, to be sure: including incessant operations (he has had “well over 60”), the impossibility of holding down a regular job because of his treatment and a terror of undoing years of painful therapy by slipping in the shower. 

On the other hand he was a big fan of his new prosthetic leg, which had been embedded in his femur: he would “recommend osseointegration to anyone,” he said. Indeed he was “looking forward to getting his right leg amputated” too, maybe a decade from now. 
He was reluctant to get it done sooner only because he still needed the painfully damaged limb for his work as a racing-car driver with Mazda, for which he also gave thanks. And he loved his wife, an occupational therapist he had met at Walter Reed. “I had this positive outlook from the get-go,” he said. “If there’s something out there that you want to do, you can either be a pioneer or else find someone who can help you out with it. 

When you have a negative attitude, no one wants to be around you, which starts screwing with your mind. A lot of guys have issues with that.”

Media coverage of the participants in America’s interminable 9/11 wars tends to focus on the health and social problems many face. Of the 2.7m who have served in Iraq or Afghanistan, 35% are said by the Department of Veterans Affairs to have a disability. That includes many with post-traumatic stress, which makes sense: patrolling built-up areas of Iraq at the height of its violence was especially horrific. And the concussive effects of blast injuries are liable to be long-term. Yet such figures may be misleading.

Many disability claims on the VA are alleged to be exaggerated or distantly related to military service. And other indicators of veterans’ well-being are more reassuring. Only 3.8% of post-9/11 veterans are unemployed, scarcely more than the general populace. Moreover, the number of soldiers officially counted as wounded-in-action in Iraq and Afghanistan is only 53,000 (2% of the total who served). And around half, having minor injuries, returned to the fray within 72 hours.

Almost two decades of war by America’s million-odd troops, waged against an enemy heavily reliant on roadside bombs, has produced around 2,000 amputees. And that surprisingly low number is despite a revolution in the survival rate of badly wounded soldiers. The Department of Defence estimates the improved tourniquet that saved Mr Dwyer was alone responsible for saving 3,000 lives—roughly half the total American death toll in Iraq and Afghanistan.

Other breakthroughs at every stage of the military medical process, from use of psychotherapy to computerised prosthetics, have meanwhile improved the long-term outlook for severely wounded vets like Mr Dwyer. Notwithstanding the well-advertised problems at the VA, they cannot doubt the government has their back—or that society does, given the thousands of veterans’ groups that have mushroomed. “I hate to see any veteran struggling, but I have to ask, have you asked for help?

Because it’s out there,” said another Walter Reed outpatient, Captain Ferris Butler, who lost his feet to an improvised bomb south of Baghdad in 2006. Unlike Mr Dwyer he admits to having been haunted by demons after his injury. But like him he met his wife at Walter Reed, has proceeded from one success to the next—in business, philanthropy and sport—and exudes positivity and derring-do.

As Americans approach what may be the last Veterans Day of the war in Afghanistan, their longest ever, they may console themselves with this thought. Contrary to the reported inundation of damaged post-9/11 veterans, their country has been remarkably unscathed by two decades at war.

Iraq and Afghanistan vets represent much less than 1% of the population. America lost eight times as many soldiers in Vietnam, in less than half the time, when its population was two-thirds the current size. The number of recent wounded is correspondingly modest and most have been looked after with immense skill and no expense spared, as is right. Otherwise, few Americans have been touched by the conflicts at all.

Who pays the piper?

Future generations will pay for them: the wars have been funded by debt.

Most Americans have had little reason to think their country is even at war. And lucky them because war is hell. But this disconnect helps explain why the country’s civil-military relations are as distant as they are. It also helps explain how America came to be locked in such long and largely unproductive conflicts in the first place.

Its voters started to reckon with the rights and wrongs of the Vietnam war—then demand accountability for it—only after they felt its sting. By contrast Donald Trump, who almost alone among national politicians decries the latest conflicts, has struggled to interest voters in them—or indeed end them.

Though mostly wrong on the details, the president raises an important question of the long wars. What have they achieved?

After thanking Mr Butler and Mr Dwyer for their service on Veterans Day (a ritual neither wounded man greatly enjoys, incidentally), their well-wishers might want to ponder that.

Bank Share Buybacks Are a Limited-Time Offer

Lenders in Europe could need to raise another $148 billion to meet the latest tranche of regulations introduced in the wake of the financial crisis

By Rochelle Toplensky

Share buybacks worth a total of $4 billion offer a rare reason to get excited about Europe’s beleaguered banking sector right now. Investors should enjoy the boost while it lasts.

In their most recent quarterly results, Swiss banks UBSand Credit Suisseand Anglo-Asian lenders HSBCand Standard Chartered reaffirmed plans to repurchase $1 billion of stock each this year.

In a tough environment, the four banks want to return excess capital to shareholders while keeping their regular dividends at a sustainable level, and offset the dilution effect of dividends paid in stock.

With their shares trading below book value, bankers also see buybacks as a good deal.

Within a couple of years, however, new rules could force big European banks to find a total of €134 billion ($147.6 billion) in additional capital, according to the local regulator’s estimates.

Buybacks are a luxury that Europe’s large lenders probably won’t be able to afford for much longer.

Most European bank results for the third quarter beat analysts’ low expectations, as a harsh climate of negative interest rates and slowing economic growth eased slightly.

Bank shares in the region are up 17% over the past three months.

The four lenders with buyback plans delivered solid core Tier 1 capital ratios of around 13% and returns on tangible equity between 8% to 10% in the first three quarters—respectable by European standards.

Barclays has also hinted at share buybacks, but last quarter £1.4 billion ($1.79 billion) of its excess capital was soaked up by a historical insurance-selling scandal.

European banks have been doing plenty of restructuring in recent years to boost returns, but with the realization that subzero rates are here to stay, possibly for years, most are looking to reduce expenses and reshape their businesses even further.

Deutsche Bank started its latest overhaul in July, with a forecast 18,000 job cuts; HSBC has promised to deliver a new plan to remodel its business alongside its year-end results in February.

The need for more capital will add to the challenges.

The European Banking Authority, the regional regulator, calculates that the region’s large banks will have to increase their capital by a quarter, assuming they maintain their current business model.

The majority of the changes are effective from Jan. 1, 2022, though some won’t be fully phased in until 2027. While many in the industry hoped the EBA would delay or water down the regulations, it has instead fully supported the new standards—though it does still have time to reconsider that decision.

European banks have been doing plenty of restructuring in recent years to boost returns. Photo: miguel medina/Agence France-Presse/Getty Images

The incoming rules are the final tranche of Basel regulations agreed after the global financial crisis in an effort to strengthen the financial system. This batch determines the level of risk a bank can assign to different asset types, with riskier assets requiring the bank to hold more reserves.

European banks need to meet the new capital requirements even as they compete against larger, richer U.S. rivals that are benefiting from higher domestic interest rates and returns—and who won’t have to find new capital. U.S. regulators, in contrast to the EBA, are expected to implement the new Basel regulations in a way that doesn’t require additional capital. They are also considering easing some existing banking rules.

With such a huge capital call on the horizon, the spending spree on share buybacks will likely have to end.

Third-quarter results offered a glimmer of light for investors in European banks, but the skies ahead are darkening.