Boom times for the global economy

But investors know that. They have been buying the rumour of strong growth and earnings so may sell the delivery of it in coming weeks. We need a new rumour to buy. That rumour could be the return of corporate pricing power.

There are more and more signals suggesting that the global economy could be entering a boom phase which could produce growth rates that we have not seen since before the 2008 crisis. For example, the Economist Intelligence Unit (EIU) forecast growth in 201 countries and territories around the world. They estimate that only four of those countries will be in recession in 2018 (Venezuela, Puerto Rico, North Korea and Equatorial Guinea). None of those four is of interest to mainstream investors.

GDP forecasts 2018 % change on a year earlier

Source: Economist Intelligence Unit, Wall Street Journal

The only thing one might question about the above map is the aggregate world growth rate of 2.7%. One suspects the EIU may revise that up in coming months because the consensus of economists surveyed by Bloomberg is for growth of 3.7% in 2018.

This synchronised global growth is something we have talked about before and more importantly is a key reason why investors are continuing to buy equities and push markets higher. It justifies the bullish projections for earnings growth which have continued to move up in recent months. The level of earnings for the global index is now expected to have risen 19% in 2017 and to rise 14% in 2018 (and 11% in 2019).

We expect equities to outperform bonds in this environment but are also conscious that the above bullish backdrop is known to the equity market and explains why it is at its current level.

“Buy the rumour and sell the fact” is a very useful old market adage. The rumour in this case is the very strong earnings growth. If it is delivered in coming weeks as fourth quarter earnings are reported, the market may well shrug its collective shoulders.

So to maintain market momentum we may need some new good news. What could make the picture more bullish?

Perhaps a general rise in commodity prices would help. Commodity prices generally rise in the latter part of an economic cycle when global demand has been strong for some time and has been persistent enough to soak up any new supply that has come on stream from mining companies investing to meet that demand.

Rising commodity prices are often seen as a negative for aggregate corporate earnings as it is believed that the positive impact on mining and energy companies, for example, is offset by the negative effect of increased costs to the rest of the corporate sector.

But analysis of the data does not bear that thesis out.

In fact, rising commodity prices are often associated with rising profit margins. This is because the commodity price increases, when they arise as a result of strong global demand, can be passed on by companies further up the value chain. Rising commodity prices generally mean companies have pricing power.

To illustrate, the chart below compares the change in the operating profit margin of the S&P500 index (green line) with an index of industrial commodity prices produced by the Journal of Commerce and Economic Cycle Research Institute (grey line).

YoY Change in S&P500 Operating Margins & JoC-ECRI IPI

Source:  Economic Cycle Research Institute, Bloomberg, Waverton Investment Management. Data: 31.12.90 to 31.12.17

There are 18 commodities included. Half of them are not traded on exchanges so their prices are set purely by demand, not speculation. All the commodities are involved in industrial production so this index does not include agricultural commodities or gold.

There is clearly a relationship between the change in the JOC-ECRI index and the change in operating margins. In recent quarters, there has been an increase in both but the rate of increase has been slowing.

However, the ECRI-JOC index has been rising strongly in the last six months (+10%) and has kicked on particularly strongly in the last month (+4%) as the chart below shows. If this continues, the annual rate of change will accelerate and the two lines on our previous chart may well be heading upwards again.

ECRI-Journal of Commerce Industrial Price Index

Source: Economic Cycle Research Institute, Bloomberg, Waverton Investment Management. Data from 03.01.03 – 05.01.18

Were that to happen, it is quite likely that earnings estimates will be raised. That would be the sort of news that could help the stock market go even higher.

Now, if corporates do begin to have pricing power, then central banks will find that the benign inflation backdrop that has allowed the continuation of extraordinary monetary policy for so long could be under threat. How policymakers respond to that will be critical to the market.

But that is a worry for the future. For now, a continuation of rising commodity prices is good for global corporates, in aggregate, and will be greeted positively by investors. A new rumour to buy?

By William Dinning

Head of Investment Strategy & Communication


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