Larry Hatheway, GAM Investments chief economist, gives market outlook

Reuters / Luke MacGregor

• Larry Hatheway, the chief economist at $145 billion GAM
  Investments, says the US stock market has reached a stage where
  it’s beyond its peak.
• Perhaps more ominously, he warns that there’s no equity
  market anywhere in the world capable of stepping up and filling
  to void left by the US.
• Hatheway outlines his thoughts in an op-ed provided
  exclusively to Business Insider.

Slumping global equity markets in October have surprised
investors. The biggest puzzle is what caused the sell-off. What
do markets know now that they didn’t know a few months ago?

Trade wars and their potential escalation? Uncertainty about US
mid-term elections? China slowing? Fed hikes? Italy’s fiscal
rule-breaking? Angela Merkel’s political woes? A strong dollar?
Higher oil prices? Hard Brexit? 

Nope, nothing new there.

About the only ‘new news’ in October is the Saudi Arabia
imbroglio. Yet few investors ascribe the global equity meltdown
to Saudi Arabia alone.

While it is fashionable to blame large market sell-offs on
‘technicals’ — algorithmic trading or index trackers dumping ETFs
— that can’t be the whole story. If the market decline isn’t
fundamental, then opportunity exists to buy at knock down prices.
Yet the reluctance of stock pickers to move in suggests they
sense something is awry.

More likely, we’ve entered ‘post-peak.’ The best of growth and
earnings is over. If so, then the litany of troublesome policies
and politics begins to matter.

Put differently, when things are good and getting better, it’s
easy to climb the wall of worry. When things stop getting better,
the metaphor becomes Wiley Coyote in thin air a few feet from the
edge of another wall — the face of the Grand Canyon.

But is it true that we’ve passed peak growth and peak earnings?

It looks that way. Consider first global growth.

In the US, economic activity peaked mid-year. Softness is now
showing up in housing and autos. Real short rates are edging back
toward positive territory (deflated by core inflation). The boost
to corporate spending from tax cuts and deregulation is happening
now. It will fade next year. Corporate taxes won’t be cut again
and the low hanging fruit of deregulation by executive order has
been picked.

Most important, the US economy is at full employment, with trend
growth around 2.5%, not 4.2% (the Q2 rate of GDP growth), nor
3.5% (the Q3 rate of GDP growth). From here, either growth slows
or inflation accelerates. And if the latter happens, the Fed will
hike rates even faster to ensure growth slows.

Can China replace the US as the world’s growth locomotive? That’s
unlikely for two reasons. First, China gets less bang for an
additional buck (renminbi) of easing. Second, China is now
relaxing credit policy to offset the risk that exports will
shrivel as trade conflict with the US intensifies. That’s hardly
reassuring. China is girding itself for the worst, not preparing
for compromise.

As for Europe, Japan or the rest of the emerging economies the
lesson is age-old. They follow, not lead, the global business
cycle. Investors could spend less time waiting for Godot.

Still, the bulls might counter, what about profits? Aren’t we in
a golden age of profitability? Surely that will lure investors
back into equities.

True, for the US and Japan the past decade has seen profit share
in GDP, return on capital and a host of other earnings metrics
scale heights never before seen in the post-war period.

Unfortunately, the best is past in the US. The share of corporate
profits in US GDP peaked at 12.6% in Q2 2012, where it then
hovered for a few years. Over the last two years, however, it has
been falling and is now nearly two percentage points below its
cyclical peak.

Why? Largely because firms have already squeezed as much as they
can out of labour — capturing the bulk of productivity gains for
the bottom line. Wages are beginning to rise, while productivity
lags. Energy costs are also rising, as is the cost of debt
finance. Lastly, as various companies have recently noted,
tariffs are pushing up prices for selected inputs.

Post-peak US profits is unnerving because in 2018 US equities
have been the only game in town. So will any equity market
replace the US?

Japan is quietly enjoying a remarkable decade-long rise in
corporate profits — but can anyone imagine Japan, alone, leading
global equity markets higher? Europe and emerging markets have
consistently failed to deliver on earnings and without an
(unlikely) acceleration of economic growth that won’t change.

In sum, when times were good and getting better, markets could
tolerate shabby politics and dubious economic policy, as well as
Fed tightening. Post-peak, that’s proving too much to ask.

So while it would be nice to think that the rest of the world can
grab the market leadership baton from the US, or that value can
replace growth as the driver of equity returns, that’s unlikely
so long as Washington, London, Rome, and a few other places don’t
start putting wrongs to right.