Brexit – Scary News Sells Best Because Of Loss Aversion by Rothschild Wealth Management
The caravan moves on
“The dogs may bark, but the caravan moves on” – proverb
Global economy still exceeds stall speed…
Fears of US recession and a hard landing in China have faded further, commodity prices seem to have stabilised, and stock market volatility has fallen back to low levels. There are some big issues still on the horizon – higher US interest rates, the Brexit vote and widening geopolitical concerns (including the looming US election, the reviving refugee crisis and the labour relations impasse in France) to name just a few. But our muddle-through scenario seems to have survived its latest test, and has been shuffling in its understated way towards the summer. The caravan moves on.
The eurozone’s table-topping first quarter GDP result is unlikely to be replicated, but the US seems to have rebounded as expected from its (upwardly revised) first-quarter disappointment. Global growth remains lacklustre, but seems still to be exceeding stall speed. Fears of another 1997-type Asian crisis in particular have subsided: they always looked overstated, and leading indicators suggest that the regional economy may be bottoming. (This does not mean China’s slowdown is complete, simply that its wider impact may not be traumatic.) Forward-looking cyclical indicators generally remain clustered close to trend (figure 1).
… and profits set to stabilize
Bellwether US corporate profits fell by roughly an eighth in 2015. This is bad news in itself for stock investors, but for many pundits a harbinger of recession. We have taken a different view. More than all of the profits decline was driven by weakness in oil and mining sectors, and lower commodity prices are not necessarily a harbinger of anything (other than added spending power for consumers). If commodity prices stop falling and the US economy continues to grow, so will corporate revenues, and operational gearing – the dilution of fixed costs as turnover rises – will support margins too.
Top lines can grow…
The possibility of revenue growth in the current climate may seem surprising. It shouldn’t: one of the many mistaken tenets of received wisdom is that there has been no top-line growth in the post-crisis period, and profits have all been driven by cost-cutting. This idea was always questionable in theory, and wrong in practice.
Revenue has grown as the US economy has expanded – and so have costs. S&P 500 Index data shows sales growing at an annualized pace of 3.8% since 2009’s low – a period that includes the recent hit to commodity revenues (figure 2). Excluding oil and mining, the growth rate has been 4.9%. The growth in US nominal GDP over the same period has been 3.4%. (US Inc receives a growing portion of its income from overseas, but its home market remains more important.)
… and costs have risen too
Individual companies can boost profits by cutting costs, but it is highly unlikely that business in aggregate could ever do so. Workers are its biggest cost, but collectively are also the biggest buyers of its output. As Henry Ford remarked, it’s not good for business to sack its customers – and it hasn’t been doing so. The aggregate payroll has expanded steadily alongside GDP since the crisis.
On a related theme – the idea that something other than business as usual has driven US corporate performance – stock buybacks can also be misinterpreted. They have been around for many years, are usually covered by operating profits and cashflow, and as we noted last month do not seem to have restricted business investment.
GDP matters – but loosely…
This is not the place to ask why people are quick to believe so much “stuff that just ain’t so”. Instead, having suggested that a growing economy will allow revenues, and in turn profits, to grow alongside it, let’s row back a little and caution against translating that GDP growth mechanically and precisely into a specified investment return. Economic growth matters, but it is not sufficient – and sometimes not even necessary – for a successful investment in stocks. It matters in a regime-setting, facilitating sort of way, not in a mechanistic one.
Figure 3 reminds us that real GDP growth is not a good guide to ranking likely investment returns across countries. China has been by a mile the fastest-growing big economy in more recent years, but a relatively poor investment. Sometimes, US GDP growth itself seems to matter more to other countries’ stock markets – perhaps because it determines global risk appetite.
This doesn’t mean there is no link at all. The relative performance of the eurozone and US stock markets is often correlated with relative GDP growth. But the link is not as reliable as we’d like, not least because so many different things affect stock markets in addition to GDP – or revenue – growth.
… and not in isolation
One obvious candidate currently is monetary policy. Decent US GDP growth is quite likely to result in a further normalisation of interest rates soon, even as inflation remains relatively subdued.
Federal Reserve officials have clearly warned us, but a move could still unsettle markets. It could also underpin the dollar, amplifying the resultant tightening of US monetary conditions.
Fed up – again?
As we see it, rising interest rates currently would signal greater confidence at the Fed in the ability of the US economy to stand on its own two feet (as we’ve long argued it can). Markets are likely eventually to share this view (a stronger dollar would be one manifestation of that). At some stage an incremental tightening of monetary conditions could prove the straw that breaks the camel’s back. But currently, we think renewed market volatility on this score might be short-lived.
Other central banks continue mostly to face the other way. Indeed, the ominous whuppa-whuppa of approaching “helicopter money” – the direct printing of circulating money, as opposed to quantitative easing – has if anything got louder in the last few weeks. We doubt such drastic action is needed, and of all the uncertainties facing us, this man-made risk may be the most troubling. Groupthink in media and policy circles is intense, and memories of the damage done by overly ambitious counter-cyclical policies in the past are fading. For now, however, we continue to draw reassurance from the fact that even in the US and UK, where labour markets are historically tight, inflation remains quiescent.
Brexit: update and implications
President Obama’s intervention in April felt like a game changer, as we noted last month. Official commentators – including the UK Treasury (again), the Bank of England, the IMF and various EU partners – have subsequently echoed his caution, and the “leave” campaign has shown signs of fragmenting as freetraders and those in favor of tighter border controls have clashed.
You don’t have to admire the government’s “fear” campaign to recognize that most independent studies of the economics of Brexit (as we noted back in December) suggest it would on balance be bad for business. We are no fans of received wisdom but it can sometimes be right.
Some economists have gone as far as