- Larry Hatheway, the chief economist at $145 billion GAM Investments, says the US stock market has reached a stage where it’s beyond its peak.
- Perhaps more ominously, he warns that there’s no equity market anywhere in the world capable of stepping up and filling to void left by the US.
- Hatheway outlines his thoughts in an op-ed provided exclusively to Business Insider.
Slumping global equity markets in October have surprised investors. The biggest puzzle is what caused the sell-off. What do markets know now that they didn’t know a few months ago?
Trade wars and their potential escalation? Uncertainty about US mid-term elections? China slowing? Fed hikes? Italy’s fiscal rule-breaking? Angela Merkel’s political woes? A strong dollar? Higher oil prices? Hard Brexit?
Nope, nothing new there.
About the only ‘new news’ in October is the Saudi Arabia imbroglio. Yet few investors ascribe the global equity meltdown to Saudi Arabia alone.
While it is fashionable to blame large market sell-offs on ‘technicals’ – algorithmic trading or index trackers dumping ETFs – that can’t be the whole story. If the market decline isn’t fundamental, then opportunity exists to buy at knock down prices. Yet the reluctance of stock pickers to move in suggests they sense something is awry.
More likely, we’ve entered ‘post-peak.’ The best of growth and earnings is over. If so, then the litany of troublesome policies and politics begins to matter.
Put differently, when things are good and getting better, it’s easy to climb the wall of worry. When things stop getting better, the metaphor becomes Wiley Coyote in thin air a few feet from the edge of another wall – the face of the Grand Canyon.
But is it true that we’ve passed peak growth and peak earnings?
It looks that way. Consider first global growth.
In the US, economic activity peaked mid-year. Softness is now showing up in housing and autos. Real short rates are edging back toward positive territory (deflated by core inflation). The boost to corporate spending from tax cuts and deregulation is happening now. It will fade next year. Corporate taxes won’t be cut again and the low hanging fruit of deregulation by executive order has been picked.
Most important, the US economy is at full employment, with trend growth around 2.5%, not 4.2% (the Q2 rate of GDP growth), nor 3.5% (the Q3 rate of GDP growth). From here, either growth slows or inflation accelerates. And if the latter happens, the Fed will hike rates even faster to ensure growth slows.
Can China replace the US as the world’s growth locomotive? That’s unlikely for two reasons. First, China gets less bang for an additional buck (renminbi) of easing. Second, China is now relaxing credit policy to offset the risk that exports will shrivel as trade conflict with the US intensifies. That’s hardly reassuring. China is girding itself for the worst, not preparing for compromise.
As for Europe, Japan or the rest of the emerging economies the lesson is age-old. They follow, not lead, the global business cycle. Investors could spend less time waiting for Godot.
Still, the bulls might counter, what about profits? Aren’t we in a golden age of profitability? Surely that will lure investors back into equities.
True, for the US and Japan the past decade has seen profit share in GDP, return on capital and a host of other earnings metrics scale heights never before seen in the post-war period.
Unfortunately, the best is past in the US. The share of corporate profits in US GDP peaked at 12.6% in Q2 2012, where it then hovered for a few years. Over the last two years, however, it has been falling and is now nearly two percentage points below its cyclical peak.
Why? Largely because firms have already squeezed as much as they can out of labour – capturing the bulk of productivity gains for the bottom line. Wages are beginning to rise, while productivity lags. Energy costs are also rising, as is the cost of debt finance. Lastly, as various companies have recently noted, tariffs are pushing up prices for selected inputs.
Post-peak US profits is unnerving because in 2018 US equities have been the only game in town. So will any equity market replace the US?
Japan is quietly enjoying a remarkable decade-long rise in corporate profits – but can anyone imagine Japan, alone, leading global equity markets higher? Europe and emerging markets have consistently failed to deliver on earnings and without an (unlikely) acceleration of economic growth that won’t change.
In sum, when times were good and getting better, markets could tolerate shabby politics and dubious economic policy, as well as Fed tightening. Post-peak, that’s proving too much to ask.
So while it would be nice to think that the rest of the world can grab the market leadership baton from the US, or that value can replace growth as the driver of equity returns, that’s unlikely so long as Washington, London, Rome, and a few other places don’t start putting wrongs to right.