Global equity market returns in 2017 were as much characterised by their lack of volatility as by their size. Benign monetary conditions, good earnings and a synchronised global expansion were the key supports. This year however, returns would suggest that those supports have been removed. In Sterling terms, the MSCI World is down -3.7%* year to date and the FTSE All-Share is down -5.9%*. Bond returns have provided little solace with UK Gilts returning -0.8%** (Source*: MSCI/Bloomberg 20/03/18; Source**: BoA/ML indices 20/03/2018). Markets appear to have concluded that time’s up on the post-Global Financial Crisis rally in asset prices.
At our recent meeting we examined each of the three supports – monetary policy, earnings and global growth indicators – to reflect on whether action was required both in our asset allocation and our investment selection. Our conclusion was that not much needed to change. The themes we had alluded to in our previous note in December remain but there is a change in tone and expectation which we discuss below.
US Real Interest Rates
In the UK, the Monetary Policy Committee (MPC) has signalled its desire to tighten policy further with expectations for another increase in rates now at 60% for May 2018. In Europe, the European Central Bank (ECB) has withdrawn its commitment to increase bond-buying if the economy weakens. Even in Japan, inflation has been rising year-on-year for 13 months in a row.
It’s clear to us that the permissive policy stance of the past has been replaced by a more hawkish one. This persuades us to persist with a negative view on interest rate risk, despite the global move higher in bond yields to date. Corporate debt might provide some yield enhancement but we continue to avoid high yield bonds where default risks are higher. Cash provides some helpful optionality (low interest rate risk, modest income and greater security of capital) as risk assets adjust to this new environment.
Whatever wage or input price pressures there might be, US corporate earnings are still benefitting from the tail-winds of easy financing conditions and, now, the President’s tax reforms. The jury is out on whether these gains will accrue to shareholders through more dividends or buybacks, or to employees through wage increases (e.g. Walmart) – but analysts are convinced that earnings per share growth will eclipse even 2017’s numbers. Sales expectations in aggregate for the S&P 500 are slightly above GDP growth expectations but not particularly elevated. The sector contributing most to the market’s higher expectation for 2018 is financials – reflecting the belief that a more “normalised” interest rate environment is supportive for profits and hence markets overall.
We are in agreement with the market that the outlook for earnings is good. Low levels of inflation (i.e. between 1-3%) have historically been good for equities and, moreover, consistent with the sort of trailing price-to-earnings ratios that we currently see. However, the risk of higher wage inflation than expected could lower profits. The margin for error is diminishing but, in the absence of a clear headwind, either through weaker growth or much higher inflation, it appears that the profit cycle has further room to run.
S&P 500 YoY Earnings Growth and Estimates
All indicators in the US appear positive for growth. The Purchasing Managers Index (PMI) and Institute of Supply Management (ISM) surveys are moving higher and consumer confidence continues to rise as unemployment rates fall. But while activity levels are encouraging we recognise the potential negatives on the US balance sheet. Public borrowing to finance the recent tax cuts will rise and then there are rising pension and health care costs to fund. This will mean an increase in the budget deficit possibly to greater than 5% of GDP. Add to that the impact of trade tariffs and the risks to the US Treasury market (higher yields) and the US Dollar (further depreciation) are not insignificant.
In Europe, real GDP growth is expected to reach 2.5% this year, the highest level since 2011. The expansion is also proving more broad-based, with peripheral economies such as Spain and Italy showing improvement. Loan demand and consumption are also growing. In the UK, by contrast, stagnant wages, negative real incomes and Brexit uncertainty are all lowering growth expectations. As discounted as many of these factors may be, our model suggests that we retain a negative view on UK stocks.
Our more favourable reading on growth is in Japan and Emerging Markets. Domestic demand is making a bigger contribution to growth in Japan than has been seen for many years. Companies are hiring more independent board directors and cross-shareholdings are unwinding. Although inflation is rising, central bank policy is accommodative. The strength of the Yen is a concern but this risk can be mitigated by allocating to more domestically orientated companies where demand is growing.
Emerging Markets have proved resilient as commodity prices have waned this year and Developed Market stocks have fallen. Although concerns remain that China could derail the positive momentum in Emerging Markets, we believe there is sufficient growth and consumer confidence to sustain activity in the region. Inflation also appears more contained than in the developed markets, supporting a continued allocation to Emerging Market debt as well as equity.
The change in policy narrative and the end of disinflation poses a risk to asset prices. Central banks are starting to move away from extraordinary stimulus to a more ordinary tightening. Corporate earnings are still supported by positive growth trajectory across the globe, with inflation in the major economies below targets. We are drawn to Japan and Emerging Markets as the more attractive areas for investment, with better fundamental and relative value. A slowdown in China or a trade war appear the most pronounced risks to our view. A combination of short duration assets including cash and other risk diversifiers should help mitigate some of this.