Our monthly market view
September 2017: This upswing has legs
- Equities overweight
- Fixed Income underweight
- Cash underweight
Confluence of factors leads to another equity upgrade
Although August proved a fairly sluggish month for global equities, the pieces are falling in place for us to take on more risk. As we illustrate below, the global economy remains resilient and our confidence in the outlook has improved, which in turn leads us to a healthy view on already-strong corporate earnings growth. Concurrently, monetary policy remains supportive; although we are moving towards policy normalisation, we are still in a very gradual and prudent mind-set amongst central bankers, providing us with a sweet spot for risky assets. Moreover, positioning is still far from exuberant and not yet reflective of the underlying, positive fundamentals. Politics remains a point of concern for investors, but we do not see it derailing the underlying picture. We thus become more constructive on risk, meaning we up our equity allocation to 10% overweight.
The global growth picture solidifies even further
Despite all the politics and the media headlines, global economic data have actually continued to improve. In fact, this summer has brought us further confirmation of the ongoing globally synchronised economic upswing; a broad swathe of GDP Q2 reports surprised firmly to the upside, showing that the bulk of the global economy is growing above trend. We take note of this broad-based, resilient growth, judging that this upturn has longer to run. Consequently, it forms a key pillar behind our decision to move up another notch on our equity allocation.
Indeed, across the global economy we continue to see good growth prospects. In Europe, for example, the macroeconomic signs remain particularly encouraging. PMIs have once again picked up in August after slight dips in June and July and remain consistent with firm, above-trend growth, further confirmed by an especially strong IFO index. Meanwhile, in the United States we are also set for decent growth in coming quarters. Nowcasts are pointing to 3%+ growth, while Q2 was also revised higher. The survey data have come in on the strong side throughout August: consumer confidence, as measured by the Michigan index, is up close to its highs, while non-manufacturing data have been especially positive. Although fiscal stimulus has increasingly looked like a distant dream, the economy continues to motor along at a reasonable pace, while the economic fallout from the latest tropical storms to the likes of Texas should only prove temporary.
In Emerging Markets, the picture remains promising. Brazil, for example, continues to inch its way back to health, with its manufacturing PMI now in expansionary territory and unemployment finally coming down too. In parallel, economic momentum in Russia too remains positive, while much of emerging Europe is also being lifted by the improved performance of the Eurozone. In all-important China, some of the data has cooled of late, after an especially strong start of the year, but a marked growth slowdown is not on the cards. Some normalisation in growth of the booming property sector is to be expected and the growth ‘floor’ set by Beijing of 6.5% remains intact, not least due to the political imperative. EM economies, then, will stay buoyant and our assertion that EM growth will outpace DM going forward stays intact.
Taken together, the global growth picture looks encouragingly broad-based and resilient to shocks such as monetary normalisation, as we discuss later. This leaves us with an environment supportive of risky assets, in which we are increasingly confident.
Corporate earnings are a key support pillar for equities
In tandem with synchronised global economic growth, corporate earnings are decisively in an upturn. Double-digit growth is likely in 2017 and just slightly softer growth in 2018, which could begin to see upward revisions, providing us with one of the best earnings outlooks in years. As we have noted in recent months, we remain in a relative sweet spot for earnings: revenues are rising steadily, while cost pressures remain subdued, meaning we continue to see an improvement in profit margins throughout most markets. The Q2 results confirm this trend, with positive surprises both on sales and earnings throughout the world.
Indeed, strong earnings growth has continued in the US. Growth was broad-based with positive surprises in all sectors and the IT sector again standing out as a leader. Looking ahead, dollar weakness as well as prospects for higher industrial production signal even more strength. In Europe too, earnings are in an uptrend, helped by the ongoing cyclical momentum noted above as well as the slow move up in yields, which aids bank earnings. The stronger euro, though, is a slight concern, but we would note that it is more of sign of strength as opposed to an outright problem. Japan meanwhile also continues currently to see clear tailwinds to earnings and it is not solely due to a weaker yen; a domestic economic upturn is underway, which is coupled with noteworthy corporate governance reform efforts, leading Japanese corporates in a more shareholder-friendly direction. Earnings momentum looks here to stay in Japan for the time being.
Not surprisingly, given these widespread in improvements, EPS estimates for both 2017 and 2018 remain steady at a high level, bucking the usual trend of the lowering of expectations as the year progresses, further highlighting the underlying strength. The earnings picture, then, is particularly amenable to a cyclical bullish view on equities.
Beyond ‘peak’ monetary stimulus but concerns overdone
The monetary policy outlook remains relatively benign. There was no breaking news to report following the Jackson Hole conference, but some concerns could be laid to rest. Leading up to Janet Yellen’s speech, there was some unease about whether she would use her topic of financial ‘financial stability’ to send any hawkish signal. If anything she did the opposite, despite some worries in the FOMC around ‘financial excess’.
In fact, looking beyond her speech, it still seems that the monetary doves have the upper hand at the Fed. This is underscored by the latest FOMC minutes that show a notable concern around lacklustre inflation and a seemingly growing consensus that the neutral rate may be lower than many have been assuming. As for the Fed’s balance sheet, it will begin to be run-down, but this process has been well telegraphed and will be very slow and measured – like ‘watching paint dry’ as some Fed officials have put it. Overall, then, in terms of our global risk-on position, nothing from the Fed makes us change our view for now.
Much like Janet Yellen, Mario Draghi did not give away much at Jackson Hole, but it is becoming clear that the European Central Bank (ECB) is beginning to consider withdrawing extreme emergency measures. In this context, there is some anxiety in the markets that a ‘policy mistake’ may occur, but this is fairly wide off the mark. There is a clear difference between moving out of ‘emergency mode’ and a full-on tightening cycle – the overall monetary policy stance in Europe will remain accommodative for the foreseeable future, as seen by extremely low real rates and not least due to the ‘institutional memory’ of the ill-advised hike in 2011 under Jean-Claude Trichet.
Nonetheless, as the ECB moves beyond ‘peak dovishness’ and begins paring back on its bond purchases next year, the euro is likely to face further upwards pressure. Whilst this will to an extent have a tightening effect, it is unlikely to have a deep economic impact. In fact, although a stronger currency is a headwind to the export sector, it is a boost to Europe’s consumers, generating higher real incomes and thus further helping the domestic demand recovery, which has been key to this latest upturn.
Therefore, in terms of risky assets, we do not see the process towards gradual and patient policy normalisation and an upward move in yields as having a deleterious impact. Gradual is the key word here and anything but will almost certainly increase very low market volatility in rates, FX and equity markets down the road. For now, though, it is too early to worry about a monetary derailment of financial markets.
Valuations should not prove a hindrance to equities
Broadly speaking, global equities are still fairly priced. Indeed, during the last couple of years, global equity valuation has been flat, and going forward, valuation by itself is unlikely to hinder equities. There are, however, pockets of stretched valuation, such as US equities and some sectors, such as Consumer Staples, meaning in some markets downside buffers are exceedingly thin. Nevertheless, on the global aggregate level stocks are not especially expensive. Thus, we still assert that equities can rise at least in line with earnings growth in the foreseeable future. Earnings growth will have to do the heavy lifting but given our expectation of a continued progress in labour markets, combined with earnings and margin expansion globally, valuation might edge slowly higher. Given that most risky bonds are yielding next to nothing in excess of government securities, and riskless rates still hover near record lows with risks tilted to the upside, equities remain unmatched in terms of risk/return outlook.
Sentiment is still far from exuberant
It remains fairly quiet on the sentiment/positioning front. Investors have kept their bias for risky assets throughout the year, and although the data points change slightly month-over-month, equity overweights remain anchored around the historical average. Speculative positions, though, have seen a large decline in net longs. In terms of flows, risky assets have had positive inflows YTD, but as cash balances also remain high the prospects for further flows are good. If anything, the North Korea/US driven risk-off in credit, volatility and risky assets during August proved market resilience to shocks by recovering extremely quickly. Overall, sentiment/positioning looks moderately cautious, not yet reflective of further upside potential. In our view, positioning reflects a preoccupation with policy risks and trepidation around the age of the bull market as opposed to a focus on the fundamental strength and ongoing fitness of the global economy.
Political risks contained for now
Investors are clearly placing more emphasis on the political environment than they have in recent years, but while volatility-inducing episodes are to be expected, the underlying positive fundamental outlook illustrated above is unlikely to be derailed by political developments.
Washington continues to generate headlines, ranging from insensitive comments by the President to resignations of key members of staff, but mostly this is of no lasting consequence. On the other hand, the upcoming debt ceiling could prove problematic, especially if Senate Democrats see it as an opportunity for brinkmanship. We do not expect it to come that far and for it to be lifted, but our underweight in US equities would benefit us if gridlock were to occur. Given relations in Congress are rancorous, markets have largely priced-out legislative action and whilst we are also sceptical, tax reform/cuts are a possibility leading up to 2018 mid-terms and could prove a positive surprise for both US equities and markets in general, but this is not imminent.
North Korea will remain an investor focal point, but beyond short-lived ‘risk-off’ reactions, it is unlikely to have an enduring market impact. In order for East Asian geopolitics to really worry us, we would have to see chances of full-scale war moving up significantly, which is however currently not the case. Despite the media hype, the Pyongyang regime is rational to the extent it wants to preserve itself, meaning a first strike against the US is very hard to imagine – a notion underscored by its recent backtracking on an attack on Guam.
Regarding the other major (geo)political events/risks, they are also largely contained for the time being. The upcoming German election is set to be a market non-event for the most part and could even turn into a positive event; Italian politics, though potentially troublesome, is an issue for next year; Brazil continues to push through reform despite the corruption cloud hanging over the government; while any flaring up of tensions between India and China will also likely prove inconsequential.
In conclusion, then, the investment outlook is supportive for risk-taking. We remain in something of a sweet spot for risk assets, marked by broad-based and resilient economic growth, strong corporate earnings as well as benign monetary policy dynamics. We continue to favour equities over fixed income and even move our equity allocation up another notch.