PORTFOLIO POINT: Global fundamentals remain strong, despite renewed market volatility, and businesses are well-placed to respond to unprecedented economic stimulus.
In this week’s piece, I continue outlining my broad thesis on why I am optimistic on global growth prospects and thus global equities more generally. In last week’s piece I showed that, following a period of intense financial instability, the global financial system is much more stable than would appear to be the case, notwithstanding periods of renewed turmoil such as we have now. These periods of turmoil do, however, provide good tactical opportunities for investors. This week I move on to discuss the second reason for my optimism. Put simply, the economic fundamentals, or the nature of the economic cycle, suggest the economic recovery that we have witnessed is sustainable. There has been too much undue worry about this.
To see this, consider that financial instability was only a symptom, albeit a very serious one, of a broader and much more traditional macro problem. It is well known that economic cycles are driven by periods of excess – and the subsequent correction in – investment. Usually, that is commercial or residential property, but it need not be confined to that. The bigger cyclical problem for the globe this time round was, of course, an overinvestment in real estate (construction, to be precise), in countries such as the US, UK, Spain and Ireland. House price gains were broader than that, but house price appreciation isn’t in and of itself symptomatic of a bubble, or the development of excess. You would expect prices to rise over time given land is a finite resource. The sustainability of that price rise is the issue, and a complicated one at that. It involves all sorts of questions relating to the quality of borrowers and the stock of housing being built, etc. But the point is that not every country that saw house prices rise rapidly over the last decade can be said to have had a bubble.
For my purposes today, it’s pertinent to note this housing excess was really only confined to a handful of nations. So for instance, while the UK and Spain saw a surge in construction, Europe as a whole saw quite modest growth. Residential building permits were only up 15% or so in the 10 years to 2007 – 1.5% per year, which is well in line with broader economic growth (no evidence for a construction bubble as such).
Chart 1: European residential construction permits
The crisis became global in nature due to those issues of financial stability that I talked about last week. It’s easy to lose sight of this simple fact given the rapid transformation of the crises into one seemingly endless crisis. Now, the essential point is that if the actual excess of residential investment was narrowly confined – and we can show that for those countries that did have an excess, progress has been made – then we should be able to take confidence that this economic upswing is sustainable, and that’s because economic downturns are caused by excess investment.
Luckily, the data suggests significant progress has indeed been made (see Chart 2 below). Peaking at over 12 months in 2009, the supply of new housing has dropped sharply to 5.3 months, which is pretty much smack bang on pre-GFC averages – and that is with sales of new homes at still very low levels (about 40% of the average). Even a small pick-up in sales activity to more normal levels will see the stock of housing drop sharply. The US could conceivably find itself with a shortage in the near future.
Chart 2: New US home sales and stock of homes for sale
With that in mind, US housing starts, following a drop of about 70% in the wake of the GFC, have started to make a modest recovery. Having said this, starts remain anaemic relative to history (about half the average). The point, however, is that they are recovering – or at the very least they have stabilised, with further gains to come if the NAHB housing market index is any guide. While housing may not be boosting growth much, the drag has certainly gone.
Chart 3: US housing starts and the NAHB housing market index
Naturally enough, house prices appear to have stabilised as well. This is more so the case in the UK and US; indeed, in Europe more broadly, house prices continue to rise. I’ve shown Spain in there as well, as house prices are still declining there (although I will return to that point in a later edition). Suffice to say, policy makers aren’t as worried by Spain. Spain is not the US, where you can just walk away from debt, and house prices have fallen a considerable way already. Global trends and local law suggest a trough is near for the Spaniards as well. This is why we are also seeing a modest pick-up in sales of Spanish homes.
Chart 4: House price index level (US, UK and Spain)
So, taking stock for moment: if global financial stability is much improved, and one of the root causes of economic downturns is really no longer with us (or has at least stabilised), then where does that leave us?
Well, there is the debt overhang, of course, but I discussed why that was misunderstood last week. Balance sheets of households and governments are nowhere near as perilous as widely believed. More importantly, what we’ve been left with is an unprecedented macroeconomic stimulus. Official interest rates are effectively still at or near zero in all the major economies, despite the fact that the crisis is largely over. This, by the way, is another reason not to be overly worried by government or even household debt levels. Debt servicing ratios for both government and households are at decade or even multi-decade lows (see Chart 5 below).
Chart 5: US debt servicing ratio (household and government)
I know there is a lot of concern over austerity, but the drag to growth pales in comparison to the monetary stimulus in place around the world; that’s why major global institutions continue to forecast solid growth in the world economy over the next few years. In any case, as recent European elections have shown us, austerity (where it is in place) is meeting fierce resistance and, of course, the US hasn’t even embarked on any significant fiscal consolidation.
Household deleveraging? As discussed last week, household balance sheets are in a very strong position. Credit growth has been weak, sure, and this is what you would reasonably expect following a housing/financial crisis. But there are signs that in some of the major economies, this process has finished. Look at the US, where consumer credit growth is surging – in four of the last five months, we’ve seen near-record growth. Retail spending has rebounded sharply.
Elsewhere, we know that corporate earnings are strong, and that companies have very low gearing and some of the highest cash balances in modern economic history. All of this suggests to me that the outlook is very bright indeed.
To sum up this two-part series, then: We have every reason to be optimistic on global growth prospects, company earnings and consequently the performance of our equity portfolios. Actions taken by policy makers and banks have stabilised the financial system. Balance sheets look much better and are much stronger now than they were four years ago. Then, when you look around the world, there isn’t a lot in the way of excess investment anymore – in fact, there are looming shortages. Noting that it is this excess which typically determines the economic cycle (downturns), households and businesses are well-placed to respond to the unprecedented economic stimulus in place. And, as the data shows, this is exactly what they are doing.