6 October 2017
As highlighted by their recent analysis from Kepler Chevreux “the verdict of equity price is that this has been a summer of consolidation.
The summer scares have proved to be unsubstantial, at least so far. The S&P500 registered no change through August (only +0.1%).
Due to the forex factor, the major indices of European equity have visited their longer-term 200 days moving averages, but they too have held (see figure 1). It seems appropriate that August ended with a new, record high for the Nasdaq composite index because in an environment of “growth without inflation” new-tech growth is the natural equity leader.
Figure 1: SXXE vs EURUSD (Inverted Right Scale)
The counterpart in Europe is the universe of small and mid-cap growth stocks, whose out-performance extended through the summer (see figure 2). The under-performance of Europe’s largest stocks this year emphasizes the region’s failure to create large companies in areas of new growth.
Figure 2: MID/LARGE cap EU ratio [blue line] & NDX/SPX [orange line]
European equity exhibits a different vulnerability this year. “Peak US$” has drawn attention to the over-dependence of Europe’s largest companies for their growth and profitability upon markets outside the region.
The summer of consolidation in the equity world is appropriate in the sense that important questions about the strategic outlook have remained unanswered.
There is a significant exception to this general rule. It is now clear that the global cycle of output and trade has continued to strengthen. The August ISM manufacturing report – the strongest since early 2011 – emphasized this message. We have always considered that the current upswing would take this index close to the highs of 2004 and 2011. In the eurozone the external influence upon the upswing in activity has become stronger than the domestic component since Q1.
Naturally, the context is especially favorable for the trading economies of SE Asia. In particular, we should not be surprised that indicators of industrial activity in China continue to show resilience, especially since the effects of a rising real exchange rate were temporarily suspended through 2015-2016.
Although China supplies positive surprises this year 2018 should bring slowdown. The strength of output and trade has begun to lift the growth of world GDP growth above the 3% pace around which it has fluctuated since the beginning of the decade. In fact, current estimates suggest that Q2 may have been the strongest quarter for world GDP growth since mid-2010. It appears that the positive momentum has been maintained through the summer.
There is another, closely related message about growth that we should not neglect. The profit content of growth world-wide has been improving. Not only is the cyclical upswing synchronized by region. It has also given rise to the most widespread revival of business profitability since the beginning of this decade, concerning every substantial region, because it has been led by producer industries. In fact, almost all major categories of equity asset – financial, industrial-technological and commodity-sensitive – are registering a degree of improvement of their profitability.
The minor exceptions are concentrated in the more defensive parts of the consumer-dependent universe.
Largely as a consequence, business investment in the major economies has been on the rise since late last year, as indicated in chart 8. There is a strong positive correlation between profitability and investment.
The scale of the collapse of profitability in the euro zone’s banking sector from 2007 to the end of 2012 was dramatic. The characteristic feature of the European corporate landscape from 2007/8 until recently has been the polarisation of profitability between, on one extreme, domestic financial value, and global companies with a defensive profile on the other.
For the first time since the mid-1990s such distortions of relative profitability within the euro area have been removed. The excess profitability of defensive global growth, exemplified by the Food & Beverages sector, has disappeared. Normal profitability is being restored to Europe’s crisis sectors, to the financials in particular.
The observations about corporate profitability are designed to emphasize the original features of the current investment context. There is no recent precedent for such a broad-based improvement in company operating profits so late in an investment cycle. Naturally, the belated profitability revival of 2016-2017 is the consequence of the multiple disturbances of the last eight years. Entire regions and entire equity categories have not participated – or only partially – in the post-2008 recovery of company profitability. We are referring to Europe especially.
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