Macro, Micro and Expectations

Macro (read “macroeconomic analysis” in financial jargon) is omnipresent in our business. All asset managers work on the assumption that financial asset prices are influenced by macroeconomic trends and it’s hard – even for the most disruptive thinkers – to argue against that idea!

The first interesting consideration, in macroeconomic terms, is the observation that the global economy is highly stable at the aggregate level, both in terms of growth and and of inflation rates. In the chart below, we show that world GDP growth (weighted sum of GDP growth rates) has been extremely stable since 2012, hovering at around 3%.

Looking back, much ink has been spilled commenting on the state of the world economy. And yet, at the aggregate level, there has been nothing to say: growth has been stable, even if lower (by roughly 2 pts) than during the previous cycle.

So why talk about the global economy if the growth rate is so stable? Simply because, at the country level , there’s a great deal more instability. In the circumstances, countries are playing a game aimed at securing the biggest slice of the world growth pie.

Our next chart distinguishes between emerging- and developed-country growth, showing that world GDP growth spanning the last 20 years can be attributed to emerging countries.

Nothing has been happening in the developed world for nearly 20 years now. The financial crisis was big, but was an asset-based crisis (linked to the balance sheets of economic agents) before becoming a revenue-based crisis (linked to income statements). Clearly, the crisis of confidence was such that revenues collapsed but, make no mistake, it was indeed a crisis of the developed world fuelled by the excess accumulation of assets and liabilities.

The developed world has since recovered and, as demonstrated in the chart, trend GDP growth ultimately posted a modest decline of less than 1 percentage point.

Emerging countries were not at the root of the financial crisis, but nevertheless were hit full-force by the resulting tell-tale domino effects (spreading of the crisis-of-confidence shockwave, freezing of USD funding channels, and currency depreciation). The emerging world ended up losing the most GDP growth points between the previous and current cycle (shedding 3-4 points, from 7-9% to 4-5%). 

The cause was not so much the financial crisis itself, although that certainly accelerated the problem. The real cause can be traced from within. Confucius say: a country cannot incessantly build more train stations and airports than the previous year. China may have done so at the height of its development phase in the 2000s, but that period has been in the rearview mirror for some time now. Today, China is building fewer airports each year than it did the previous year. The total number of installed airports is climbing, but investment in the macroeconomic sense is on the decline.

China’s ambition to transition from a society of manufacturers to one of consumers is the result of this analysis. Sustaining a high investment growth rate is harder than sustaining household income growth.

Looking beyond this widely accepted concept, the steep drop in EM GDP growth pts. in the current cycle also points to a huge disparity. “BRICS” has lost all meaning, if it ever really had any. They may well be the top five countries in the emerging world, but that’s now the only real thing they have in common.

The chart below presents GDP growth in the BRICS countries. It speaks for itself.

As an acronym, “BRICS” is ready to be retired, being no longer relevant. Another way to illustrate the major differences among emerging countries is to examine sovereign bond yields (see chart below). The inset shows the latest data percentile. Brazil is currently trading at a 0 percentile level, versus 74 for South Africa! Meanwhile, China is sitting at percentile 21 and Russia at 67.

What’s the message here? 1) World GDP growth is stable, 2) Local GDP growth is a mixed bag, much more so in the emerging world than in the developed world (standard deviation of GDP growth rates 2.5x higher for EM countries in recent years), and 3) The emerging world is an amalgamation of very different track records, with widely varying financial conditions.
 
Earlier, we referred to a game aimed at securing the biggest slice of the pie. That is especially true when it comes to profits, which is where listed companies come into play. Below, we compare the distribution of world GDP with the distribution of market capitalisation on the MSCI World by country. A “Winner Takes All” market if there ever was one. How is it that US corporations are walking off with the biggest piece of the pie, leaving the euro zone and emerging countries to pick up the crumbs? Other countries (like Japan, Europe ex. euro zone and other developed countries) are also doing pretty well for themselves.

The answer to this question is what makes our business so appealing, because untangling and understanding these macro and micro issues are the keys to generating performance. Why was 2018 such a tough year for asset managers? Because these two macro and micro factors failed to deliver the expected performance. Why is that?

The chart below compares the sector performances of three investment universes in 2018: US, Europe and Emerging Countries, with the change in their 12-month projected EPS. Historically, we see a strong positive link between the two: the top-performing sectors are often those whose projected EPS increases the most. In 2018, this correlation was turned on its head: smart analysts (namely those able to focus on the right issue from a fundamental standpoint) were those that underperformed the most. That is why 2018 was such a hard year: because the fundamental bias so deeply ingrained among asset managers underperformed.

Our take-away, consequently, is that micro and macro analyses are not enough and we have to think outside the box!

It’s surprising to see the consensus among asset managers and strategists as we head into 2019. They’re all convinced that only the end of the economic cycle (a recession) can put an end to the equity market cycle, and that today’s more attractive valuations are acting as a support. What a strange take on the situation! “Fundamentals” didn’t work in 2018, so the right strategy for 2019 is to say: “This time they’ll work”?

This consensus – that the global economic cycle is resilient, that what we’re currently seeing is just a slowdown, that China is handling its downturns like it always has, etc. – and that the equity markets can thus be counted on to perform again, is very simplistic, in our view. Not to mention it ignores what happened in the second half of 2018.

Clearly, the variables that need to be added to the equation are positioning and “expectations”. We can’t understand the decline in the Nasdaq or in US long rates without looking at investment flow dynamics. All investors were long US tech stocks and short US bonds. The reason these asset classes took a turn for the worse is internal, not external: it was the usual story of fatigue followed by exhaustion and ending with positions being unwound in a snowball effect. It had nothing to do with fundamentals.

Expectations also had a colossal role to play with tech stocks. Take the Nasdaq 100’s top performer in 2017, for example: Align Technology, the leader in dental alignment solutions, saw its share price skyrocket 131%. The company continuously exceeded analyst expectations in recent quarters, driving their estimates to new heights. In Q3 2018, the company once again beat the consensus, but warned that Q4 earnings would not meet analyst expectations. In fact, it announced that Q4 earnings would be on a par with the analyst consensus from the previous year, i.e. before their estimates had been raised. The share lost 25% in two days. This is a classic illustration of the “expectations cycle” in the financial markets.

The problem with the financial markets in 2018 was not that a small percentage of goods imported into the US was hit with a 10% tariff, but rather than many assets had reached an extreme polarisation point in terms of positioning and expectations. So the question for 2019 is whether or not any adjustments have been made. Have expectations and investor portfolios been adjusted, or has nothing changed at all because everyone is still clinging to the certainty that the economic cycle is not over? As we see it, that’s the real question, because the rest – macro and micro – we already know.

Tristan Abet

The comments and opinions expressed in this article are those of the authors and not necessarily those of Candriam.