Earnings growth continues to provide support to global equity markets
- Tuesday, January 2, 2018
Investors have experienced strong total returns in 2017 across a range of asset classes. The combination of good growth numbers, low inflation, low interest rates and reduced volatility has aided the economic conditions.
At the beginning of the year we were uncertain about the impact of Brexit, Donald Trump’s presidency and a number of European elections. Throughout this year of change, market volatility has remained subdued as markets took these political risks in their stride.
There has been a noticeable pick up in global growth since the summer of 2016 which fortunately coincided with our Brexit Referendum. This economic pick up is still continuing at a rate of around 3.6% global GDP according to the International Monetary Fund (IMF). Developed economies are enjoying some of the strongestgrowth since the financial crisis resulting in greater employment across Europe and particularly in America and Britain where unemployment is at record low levels. Given this backdrop we now expect a burst of inflation. This has started to occur in the UK where inflation hit 3.1% in November mainly through the higher costs of imported food, goods and oil due to a devaluation of sterling. Inflation in the US is standing at 2.04% while in Japan it is 0.7%. Despite strong labour markets and loose monetary policy we are not seeing further rises in inflation in other developed economies. Governments have been able to allow their economies to grow at accelerated growth rates without creating a looming inflation problem which would require interest rate hikes to rein back. Due to the combined impact of globalisation, national and personal debt levels, the gig economy, disruptive technologies and developed world demographics the price power of labour is lower than would be expected and hence wage inflation is muted.
The global economy is undergoing its best ever growth phase with fewer countries currently in recession than ever. There is a general lack of signs suggesting a deceleration in global growth with the Purchase Manager Index (PMI), a key measure of market confidence, indicating positive across the globe.
Despite the high valuations placed upon developed world stock markets, high profits and expectations of earnings growth continue to provide support to global equity markets. This however does not stop us being cautious about the future direction of markets.
With improvements in growth and unemployment the US Federal Reserve has progressively increased interest rates and in October also started a programme of unwinding its massive quantitative easing (QE) programme. The Feds balance sheet currently stands at US$4.5tn while pre crisis it was US$1tn. As bond assets come to maturity they will not be renewed therefore reducing the asset values held by the Fed by US$10bn per month. This amounts to switching from the largest moneyprinting exercise in history to the largest money recovery exercise in history.
The Federal Reserve’s tightening of money has been well signalled and markets have taken it in their stride seeing it as a sign of the strength of the economy. However, there are natural concerns as no one knows exactly how this monetary tightening will impact the economy. Printing money inflates asset prices and QE has produced big increases in stock, bond and property prices. However, the impact on wage rates, incomes, and goods and service’s prices has been much slower.
Other central banks will want to follow the lead of the Fed in returning to normal economics. We have seen interest rate rises from the Bank of England (BoE) while the European Central Bank (ECB) has announced the tapering of its QE programme starting in 2018. The Bank of Japan (BoJ) however remains committed to zero interest rates and continuing its QE programme until inflation returns to the Japanese economy.
Another source of global growth is government spending. It would appear that globally the era of fiscal austerity has come to an end. According to the IMF, government spending will boost global GDP by 0.4% in 2017. During the period 2010 – 2015, government cut backs were a drag on growth.
As far as equities are concerned global markets have had a strong year and we remain positive about 2018. However, equities have reached historical highs in the US, UK, Europe and Japan and we have to be mindful of where value is to be found. With some markets at or close to fair value it is more difficult to grow returns. We need to be more selective and diversified. We see Europe, Japan and Asia as offering better value than the US due to lower valuations and ongoing recovery.
The US S&P 500 reached new highs in early December by hitting 2642 points up from 2250 at the start of January meaning the US leading index grew by around 17.4% in 2017. Much of the growth comes from improved corporate earnings, particularly in the technology sector with companies like Facebook, Apple, Amazon and Microsoft doing very well. We do however see the US stock market as expensive but still profitable.
Market sentiment has not been dimmed by the ongoing failure of the Trump administration to realise many policy goals. The Senate Republicans did however pass the most radical overhaul of US taxes in 30 years on 2nd December, giving Donald Trump the chance of achieving his first legislative victory of his presidency. While there is expectation of personal and corporate tax reform in the USA, this may still stall in Congress due to the additional medium term cost to the national debt of some US$1.2tn. Asset managers believe there will be some tax reform but this will not have as much impact on asset prices as originally expected.
UK stock valuations are historically high having been encouraged by analysts revising their earnings expectations. However, without the tailwind that was the devaluation of sterling, we can expect a slowdown in the UK driven by weaker business investment and higher inflation reducing consumer spending. Although there has been some slowdown of investment and capital inflows, export orders have remained buoyant. The Bank of England’s rise in interest rates from 0.25% to 0.5% was aimed at dampening inflationary pressure.
European companies are benefitting from improved global growth and loose monetary policy. Eurozone equities are relatively undervalued compared to the US and earnings are more likely to exceed expectations. European stocks have benefited from a catch up effect on earnings growth and valuations this year. The FTSE Euro First 300 index rose from 1445 in January to a high of 1560 in November, a rise of 7.9%. It stood at 1509 on 1st December.
We remain positive over Japanese equities as they are showing strong earnings growth and analysts have reviewed upwards their earnings forecasts. The Nikkei 225 Index gained 14.8% between January and November 2017. The market rise was led by oil, mining and car manufacturing. Economic data continues to improve with inflation now standing at 0.7%. Japanese companies are recruiting from a tight labour market thus pushing up wages. The BoJ has kept interest rate at 0% and the gradual but consistent improvements in the economy have been reflected in corporate results.
The developing Asian markets remain the most attractive region on a valuation basis particularly Hong Kong, Taiwan, China, South Korea and Thailand. This region is the world’s growth engine based upon export growth, increased domestic consumption and supportive monetary policy. Improvements in corporate governance andstructural reforms have also been helpful. The consensus amongst economists is that Asia will enjoy a growth in GDP of 5% in 2017 and 5.1% in 2018. One of the major Asian stock market is the Hong Kong’s Hang Seng Index. It increased in value from 22000 point in January to 29341 in November, a rise of 33%, but dropped back to 29074 by 1st December.
For investors with high risk tolerances, Brazil and Russia have improved growth prospects and look more attractive than in the recent past. Russian equities in particular have delivered strong performances. Russia’s economy is largely based upon natural resources and energy therefore any increase in the oil price will add value to Russian stocks.
While most equity markets are trading at relatively high values there is always nervousness about a correction. We are not expecting this given the relative strengthening of the world economy and the potential for further growth. Investor sentiment should therefore remain intact. The risk to this centre around geopolitical risks in North Korea, Catalonia, anti-trade initiatives from the Trump administration, a decrease in credit confidence in China’s regional banking sector or the Federal Reserve hiking interests rates too much and too soon. While these risks are material none of them seem at this stage to be a high risk to markets. This situation can of course change.
UK stock valuations are historically high having been encouraged by analysts revising their earnings expectations.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.