Stockwatch: The big issues for UK equities

Settle back for a Goldilocks scenario, or beware the calm before a storm ahead? The first quarter of 2017 has seen the first widely-based upturn in global economic growth for three years, serious profit warnings have been scant, and strong US corporate earnings led cheer-leaders such as Jeremy Siegel to re-assert bullish prospects for equities.

This Wharton Professor of Finance argues it's the first time he's seen forward guidance maintained or increased since 2009, defying the pattern in recent years where companies reduce expectations progressively to December. According to one data compiler, overall US net profit growth for 2017 is predicted at 9.9%, which begs the question what this assumes about Trump reflation plans in a sluggish macro context.

The sense of "Goldilocks" derives from modest inflationary pressures that should not force the US Federal Reserve to hastily raise interest rates, hence a not-too-hot, not-too-cold environment that is typically good for equities. Amid zilch returns from bonds and cash, where else do investors go?

Equities continue to climb a wall of worry

That US stocks fell the most in eight months on 17 May, shows lingering wariness. You could interpret that positively, applying a check on exuberance thereby a climax less likely. Meanwhile, in the opposite professorial corner, Robert Shiller asserts the US market hasn't been so overvalued except in 1929 and 2000.

The two gurus have just engaged a TV spat where Siegel rejected Shiller's use of an historic 10 years' cyclically-adjusted earnings approach, alleging three quarters of zero net income during 2008-09 has distorted the "CAPE" valuation model considering US companies have on average delivered $76 over three quarters during 2016. Such an exceptional low, he contends, is a once-in-a-50-year event or even a 74-year event that won't be repeated. "We have everything moving in tandem."

Meanwhile, President Trump's budget proposals, on which the post-election Wall Street rally is based, now head to Congress which has ultimate power whether to make them reality. It's a big demand politically, appearing to benefit people in upper income brackets while reducing support for those on lower incomes.

Underlying Trump's plan to "eliminate" the US budget deficit his team projects 3% annual growth, steady inflation of 2% and modest interest rate increases - the kind of environment that would typically support productivity and a rise in employment - although the Fed projects a 1.8% annual growth rate in coming years. How the proposals fair with members of Congress will be a chief influence on US stocks.

Crispin Odey remains stubbornly bearish

This British hedge fund manager can come across like a stopped clock, than alter his thinking in light of monetary stimulus and scant returns from cash. His latest letter to clients insists the 2008 crisis resulted from "large widespread borrowing by individuals who could not repay their debts" and what has got us out of the crisis has been more of the same.

Certainly, I've drawn attention to levels of UK consumer borrowing approaching the 2008 peak and car-purchase finance showing bubble features; whether or not a majority of such credit constitutes "sub-prime" as Odey appears to contend.

It would seem to need a sudden downturn - in response to some unexpected event(s) - hitting incomes, as latest data suggests the return of inflation is weighing only steadily on spending.

Yet IMF is positive on UK/US economies

For what mainstream forecasting is worth, latest data from the International Monetary Fund looks for 2% UK growth this year behind the US at 2.3%, with the possibility the UK will slow to 1.5% in 2018 below several of the G7.

The Conservative Party manifesto claim that the UK is nowadays the fastest growing economy in the G7, is selective. Indeed, it was true in 2014 when 3.1% growth was achieved, although in 2015 the UK slipped to second place at 2.5% behind the US at 3%. In 2016, Germany and the UK both lead the ranks with data suggesting an equal 1.8%.

So, the international context similarly implies a major upset is needed to trigger the debt crisis Odey reckons is due. He cites a UK gross savings rate of 6% versus a necessary investment rate of 11% of GDP: "With the Bank of England's encouragement, consumer debt is rising at 8% a year while wages are only rising by 2%. How long this madness?"

China's credit rating cut for the first time in three decades

Odey's observations on debt parallel Moody's cutting China's foreign credit rating - modestly, from A1 to Aa3 - given financial strength will likely deteriorate as debt keeps rising and the economy slows. The rating now matches Japan, Saudi Arabia and Israel - hardly as if a crisis is imminent - although Odey contends China's 10.6% consumer spending growth and 7.6% economic growth, has resulted from injecting the credit equivalent of 40% of GDP into the economy last year.

An attempt to rein back this credit since March has promptly hit growth and spending and explains circa 20% falls in China-related commodity prices.

"All of these instances of slowdown since March are threatening the reflation trade which has driven stock markets up and bond markets lower," he suggests. We shall see in due course whether this starts to affect guidance from mining companies and the like.

Stockmarket indifference to increased Conservative majority?

While this remains the likely outcome of June's general election, Theresa May's centrist policy platform implies shareholders a target for tax revenue-raising, despite serial raids on dividend income. The current Conservative Party has nothing like the popular capitalist agenda of Chancellor Lawson in the 1980s, nor even New Labour's Brown during his 1997 to 2007 chancellorship - whose Business Asset Taper Relief meant negligible capital gains tax e.g. on most AIM-listed stocks held over two years.

The Conservatives have undermined long-term investing with abolition of taper relief altogether, allegedly to "simplify" investment, and further attrition of shareholders looks likely. Today's institutionalised stockmarket is anyway likely to take its cue from overall trends in the UK economy and corporate profits, so don't assume any post-election rally now the cyclical upturn since 2009 is so long-lived, and a new government will need to get unpopular tax rises made soon in its new term.

It's nothing to celebrate, like how US investors rampaged in response to Trump. The considered key issues for UK equities are how wages and consumer spending trend in context of renewed inflation; whether some of the bullish earnings forecasts need trimming back. Jeremy Siegel rightly identifies a crux for valuations, although I'm not convinced we'll see an extended episode of "Goldilocks" in Britain.