Our monthly market view
July 2017: Let the sun shine
- Equities overweight
- Fixed Income underweight
- Cash neutral
Global financial markets moved largely sideways in June, despite oil entering its 5th bear market since the Great Financial Crisis (GFC) and hurting pockets in equity and credit markets. Oil is, however, less ‘systemically’ important than during its last downturn, explaining why it is not dragging the rest of the market down with it. The UK election produced headlines, but its market impact remained muted. Meanwhile, market responses to central bank decisions were also subdued, noticeably following the Federal Reserve’s hike and balance sheet taper announcement.
Turning to the global economy, it remains in a cyclical upturn, which started late last summer. The level of leading indicators continues to signal further improvements, albeit at a slower pace. Soft indicators, especially in the US, have turned lower and are disappointing elevated expectations, following the abrupt sentiment improvement in late 2016/early 2017. Nonetheless, the level of soft indicators is still consistent with advances in hard data, which will drive earnings and ultimately equity returns in coming months and quarters.
Although the economic data in the US have been somewhat lacklustre of late, the economy is set to expand at trend pace in the coming quarters, supported by the usual seasonality in data since the GFC (growth has tended to pick up after Q1). In Europe, data are beating expectations handsomely; PMIs and other indicators are at high levels, affirming a stronger-than-expected growth path, materially above potential. Japan, while not particularly impressive, has seen early signs of improvement in its domestic growth picture and external factors remains supportive as well. However, the Japanese economy has endured countless false starts in recent years, meaning we remain hesitant in embracing Japan’s recent turn for the better in our strategy. Across developed markets (DM), growth is moving from an acceleration phase to a more level growth trajectory – at a higher level.
Meanwhile, Emerging Markets (EM) are showing strength. We expect the EM growth gap versus DM to widen during the first half of 2017, marking a reversal of 5 years of declines in relative growth rates. The upturn in global trade is set to continue, given the steady advance in DM industrial production, leading also to a stabilisation of EM currencies. At the same time, the pressure on base metals is abating, although some concern remains around commodities sensitive to China’s ongoing clamp-down on shadow banking and speculative excess. Lastly, falling oil prices, caused once more by US-driven supply expansion, will have significantly smaller adverse impacts on the economy than in 2015-2016, when the energy sector was much larger in both nominal and relative terms.
Overall, then, the global growth cycle continues to improve in a largely synchronized manner, providing potential for ongoing positive synergies and a continued global earnings growth at multi-year highs. This ensures we have an economic environment supportive of risky assets.
Moving to DM central banks, the central message is that they will become less accommodative and rates will edge higher as political worries recede and activity expands. The Fed appears strongly committed to normalising policy, as easier global financial conditions allows them to do so without repercussions. In Europe on the other hand, the ECB has kept a dovish tilt recent months, but some question marks have arisen after Draghi’s June 27th speech on the need to adjust policy parameters given strong growth. And it does look as though risks for European yields are tilted to the upside now, and if the moves prove too fast, it would likely be unsettling for risky assets. Slightly longer term, though, we do not see higher yields as a major risk. Indeed, a ~50 bps move higher in the long end throughout the remainder of the year should be readily absorbed by the equity markets. Looking at the major EM countries (outside of China), the bias is the other way around – towards loosening – though without deep and widespread rate reductions being on the cards. In general, though, central banks remain supportive in EM.
As we are between earnings seasons, the focus is on corporate guidance and analyst revisions. Our view is that the strong trend in earnings will continue in Q2. While Q1 was boosted by base effects, beats were simply overwhelming, both in terms of depth and breadth. Going forward, Q2 will not benefit to the same extent from base effects, meaning growth will be lower, but still at an still impressive level. Moreover, it is highly likely, that analysts have been too cautious in revising up their expectations in line with the strong Q1 beats, mean renewed beats are again likely in Q2. In that case, double-digit global earnings growth is almost a given for 2017 as a whole. Lastly, a little overlooked during this earnings upturn is that it is predominantly being driven by improvements in company top lines. Given fairly high operational leverage, especially in Europe, stronger sales will result in better margins, lifting earnings growth visibly Following Q2 reports, market attention will begin to shift to 2018 outlook, which remains somewhat unaffected by this year’s impressive earnings momentum and therefore could be the next driver for equity advances. The earnings outlook constitutes one of the key arguments for our overweight stance in equities as the market still might not have fully appreciated the force of earning as a market driver in coming quarters.
Valuations will not in themselves be an obstacle for equities. Taking a long historical perspective, equities are not yet especially expensive, particularly not if you look outside of the US. Valuation is up about 5% since late last year, as markets have repriced for higher earnings growth. We still believe equities can rise at least to the tune of earnings growth in the foreseeable future. Earnings growth will have to do the heavy lifting but given our expectation of a continued earnings expansion, valuation is by no means set in stone at today’s levels, and has room to expand further. 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.
In terms of positioning, asset managers remain overweight equities around their historical average, which is usually consistent with decent equity performance. Speculative positions have dropped sharply and appear unusually low compared to the level of volatility, which is supportive of equity performance from a contrarian perspective. Moreover, the mid-month mini crash in Tech leaders, just after the Nasdaq touched cycle highs, confirms the tendency for shallow and short-lived dips to be bought. No surprise, then, to see capital flows favouring risky assets and we see no reason for this to change currently, given safe bond yields at even less attractive levels. Riskier fixed income securities in corporate and Emerging Markets have received the bulk of bond inflows, while secure sovereign bonds (outside of the US) are in the red, despite yields having declined recently. Within equities, Europe continues to be a beneficiary, while the US is seeing outflows at the moment. Most of our short-term sentiment indicators have recovered after the risk-off seen the last couple of months. In conclusion, sentiment/positioning is tilted to the positive, without being anywhere near exuberance.
On the political side, investor concerns continue to ease. Political noise in Europe has died down markedly; we saw a favourable outcome of the French parliamentary election, while risks around Italy remain overstated and the UK election proved to be a non-event for markets. In the US, Trump’s policy agenda continues to moderate when faced with Congressional and legal realities as well as recent allegations of impropriety – the implication being that tax reform/cuts will be later and smaller. Geopolitically, concerns centre on the Korean peninsula, but a full scale conflict remains highly improbable. In the same vein, the isolation of Qatar is also highly unlikely to have larger ramifications. In Brazil, political concerns have clearly risen in reflection of the corruption allegations against the president, but, for now, parliamentary support for Temer remains intact, while the negative effects will also be confined to Brazil.
In conclusion, the investment outlook is supportive for risk-taking. Valuation and late cycle dynamics suggest treading with some caution, but for now we remain in something of a sweet spot for risk assets, marked by decent economic growth, strong earnings and declining risks. We continue to favour equities over fixed income.