Last year the economy was the absolute protagonist on the markets. The economists' estimates at the start of the year were clearly beaten, which rarely happens. The case of Italy is emblematic, at the beginning of the year the average estimates by economists predicted growth of less than 1% while now it has reached 1,5%.
Furthermore, economic growth has proved to be highly synchronized in all major areas and, for equity market investors, this is a very positive sign because it implies a low risk of recession in the short term – for example, if a shock on consumption in the Eurozone in a context of good global growth would probably help foreign trade avoid falling into recession.
These very positive trends, together with the expansive policies of the central banks, have made it possible to make the stock market immune to numerous potentially delicate political events, from the United States to North Korea, from Spain to Holland and Germany.
For 2018, economists expect 3,8% growth globally, a similar level to last year. Contributions to global growth will be marginally different from last year as the United States will benefit from Trump's tax reform while the eurozone is expected to decelerate due to the strength of the euro. China will most likely remain the main engine of growth in the world economy, contributing just under a quarter. China's growth is not risk-free given the rapidly rising debt of state-controlled companies, but a short-term crash is unlikely with the economy propelling to over 6% growth.
The above summarizes short-term forecasts, but what is more important for businesses, society and states is that we are in the midst of a real technological revolution that began at the beginning of the century. Robotics is becoming more and more popular, we are all connected to the internet – as are many of the objects we use every day and which produce an unprecedented amount of data. Artificial intelligence is the new frontier that will make machines more and more in competition with humans.
Finance is permeated by this structural change, technology stocks have been the absolute protagonists in recent years and, today, the world's top five companies by market capitalization on the global index are all technology (and US). Another dimension to take into consideration is linked to the automated activity on the markets which, in the United States, now sees well over 50% of exchanges decided by algorithms without human intervention. The eurozone is lagging behind on this front, but we are also experiencing rapid growth here.
I'm sure many readers have less of a perception of good economic data than a positive feeling about the ongoing technological revolution. Indeed, some mechanism in the relationship between technology-economy-society seems to have jammed. First of all, global economic growth – although better than in the years following the financial crisis – remains far below the levels reached in previous decades and, above all, in the 50s, 60s and 70s. It's not about growth rates that might suggest a technological and productive leap in progress. Moreover, despite the unprecedented injections of liquidity by central banks and negative interest rates in most of the advanced economies, inflation also remains well below the targets of central bankers.
However, the datum that more than any other calls into question the ongoing technological revolution is that of productivity, which is growing at a much lower rate than in the past, both in the United States and in the Eurozone. As stated by Robert Solow, Nobel Prize in Economics in 1987: “We see the computer age everywhere except in productivity data”. Some disruptive technologies can actually have a destructive impact on some traditional sectors, think of the reaction of US supermarket chain stocks following the Amazon acquisition of Whole Foods: they lost more than 10% in the following three months underperforming the index of 12%.
The paradoxes we have illustrated, together with some political choices of advanced economies and globalization, have led to a growing polarization of society. Since the height of the financial crisis in early 2009, the US stock market has nearly tripled in value, home prices have performed nearly as astoundingly and, despite unemployment falling to historic lows, US household incomes they have remained mostly stagnant. A comparison with the Eurozone is difficult to achieve because our economic area has different economic policies in the various countries, but it is clear that the scenario is, all things considered, similar.
These growing inequalities have inevitably produced a strong distrust of institutions and political representatives on both sides of the Atlantic, creating fertile ground for the affirmation of various forms of populism which, in some cases, has even reached government roles. The eurozone is a good example of the implications in terms of political fragmentation. In Spain it took almost a year to form a government after the 2016 elections, in the Netherlands 225 days, in Germany discussions on various possible alliances have continued since last September, while in Austria the far right has taken key ministries. Italy, of course, is not immune from this trend and is present at the next vote of 4 March with polls pointing to the formation of a grand coalition or, perhaps, prolonged ungovernability.
At the 2018 UBS Forum, we therefore attempted together with Alberto Vincentelli, Professor of Technology and Innovation at the University of California, Berkeley, and our chief global economist Paul Donovan to answer a few questions: why are new technologies not driving productivity? Are these deflationary technologies? Who benefits from the technological revolution? What are the political, economic and market consequences?
There is no single answer to these questions, but a combination of factors which, together with economic policy choices, have contributed to the current situation. Furthermore, a flexible approach must be maintained with regard to economic data, which are produced on the basis of indicators created in the last century which, at times, are ill-adapted to today's reality.
At least initially, a leap forward in production systems leads to a loss of employment. Some estimates suggest that between 10% and 14% of jobs will be lost. What has happened following the other industrial revolutions is that, after the initial shock, the demand has increased for goods that have become more accessible (think of the assembly line and the Ford T, the first accessible car), the demand has always become more sophisticated leading to new job creation. It is a long process with many uncertainties.
Technology itself is not inflationary or deflationary, initially a technological revolution can lead to lower prices of some goods but, in the past, all technological revolutions have led to periods of high inflation. Today we see that the way we consume some goods and services has changed (let's think of music with the transition from CDs to applications that make a music library available) causing their price to drop. We have not reached the next step, the formation of a new demand or a phase of such optimism that it leads to a general increase in prices.
Finally, it should be remembered that not all innovations are necessarily intended to increase productivity and, consequently, to produce wealth. Some can only be aimed at improving the quality of life which is in any case a wealth in itself, even if it escapes the traditional statistics and economic data that are produced today.
The topics covered are so pressing that of the 17 goals that the UN has set itself for sustainable development, more than half are related to reducing inequalities and creating more inclusive economic models, a greater number than the goals related to the environment and climate change, which is most often talked about.
What are the conclusions of all these considerations? The technological transformation underway is unstoppable and the greatest risk for a country is to fall behind in terms of investments and skills. Hiding behind populism is a serious danger that could lead a country to become marginal from an economic and strategic point of view. For individuals, especially the younger ones, it can easily be understood that in a scenario of this type it will be even more important to have high-level, flexible training and in-depth knowledge of new technologies.
An investor, on the other hand, has multiple levers to position himself in this context. Meanwhile, the rule of diversification is more valid than ever in this context where any sector can be put in crisis by a technological change (see the previous Amazon-Whole Foods described above), moreover there are opportunities in sectors destined to benefit from new technologies, from robotics, digitization and data management.
Investment strategy for the first part of 2018
After the excellent performance of the stock market, I think everyone is wondering about the duration of this positive phase of the markets that began way back in 2009. Let us examine three themes that will probably prevail over the others: the strong trend in corporate earnings, market valuations still reasonable equities and, on a more cautious note, central bank braking since the second half of this year.
As far as corporate earnings are concerned, it must be said that the 2017 financial statements, which will be published in the coming weeks, will probably be the best in ten years for most product sectors and geographical areas. This is a trend which, according to analysts' estimates, should extend into 2018 with growth rates exceeding 10%.
Earnings trends lead us to valuations, because what matters for the markets is not the absolute value of an index or the price of a share but the relationship with the profits produced. If we look at the global stock index, today the price-to-earnings ratio has reached 20 times and is in line with the historical average. To be clear, in 1999 he went over 30 times. If we look ahead to next year based on analysts' estimates, we're down to less than 18x, which makes us think the stock market still has potential left over. We increased our equity overweight – concentrated in global equities with smaller positions in the eurozone and emerging markets versus the UK and Australia.
The third theme this year is the slowdown of central banks and above all the ECB which will interrupt the injection of liquidity from September. What will be the consequences of this change of direction of central banks? It is difficult to predict but there are two more likely impacts. The first concerns the rise in yields, in particular on European bonds and, primarily, on government bonds on which we have recently increased our underweight. The second concerns the increase in equity market volatility – which fell to historic lows last year and at the beginning of this year – which will require a more dynamic and agile approach.
*** The author is Chief Investment Officer of UBS Wealth Management in Italy
