Our monthly market view

November 2017: Ease off the pedal

Recommendations:

  • Equities overweight
  • Fixed Income underweight
  • Cash neutral

 
Shave the equity overweight

After a strong two-month rally in global equities, we recommend moderating the equity overweight. The main reason here is that investor sentiment has become quite extended in the short-term. While we did manage to catch the excess pessimism in late August, that tide has turned and is no longer giving that extra boost to returns going forward. Turning to the fundamental picture, however, the outlook remains as promising as it has for some time. Specifically, the global economy still enjoys solid momentum, lending support to continued strength in corporate earnings growth. Valuation, meanwhile, while not exactly a tailwind for risky assets, is far from levels which would impede further gains in the stock market. On the other hand, monetary policy is slowly tightening across the developed world. On aggregate, however, monetary conditions will remain easy. Finally, although politics is a concern for investors, a lot needs to go wrong for the supportive underlying picture to change. We thus remain positive on risk, but take some profits and cut our overweight recommendation for equities to 5 %.
 
The global economy motors on

The last months have continued to produce strong economic data the world over. Indeed, the US, the Eurozone and Japan have all continued to impress; on top of inspiring GDP measures, forward-looking indicators, such as PMIs, have been impressive and hitting new multi-year highs, especially on the manufacturing side. Overall, the last three months have seen better-than-expected macroeconomic figures emerge from developed countries, with the Eurozone and Japan at the forefront while the UK and the US are also finally surpassing expectations.
 
Nonetheless, some indicators, particularly in the US, have suffered from the devastation caused by the hurricanes Harvey and Irma. We expect these impacts to be transitory, but they are already causing demonstrable volatility in US economic indicators. Investors, though, should overlook these effects, as they will be reversed in the coming quarters, as has historically usually been the case following these types of disasters. Taken together, the developed economies remain on a firm path.

Emerging countries have also, by and large, provided markets with positive data. China has continued to provide the markets with impressive growth figures, as the Q3 GDP data confirmed. In addition, Eastern Europe and Brazil remain on the right track, showing accelerating growth, although the steepest rise in these improvements is likely behind us. India, on the other hand, has disappointed somewhat of late, but as the reform drive continues, growth should pick up again. From an investor’s viewpoint, then, the global economy continues to steam ahead in a synchronized manner, propelling corporate earnings growth.
 
Corporate earnings a key support pillar for equities
 
As the global economy motors on, so do corporate earnings at a pace witnessed only once after the financial crisis. On top of a strong, synchronized economic upswing, companies’ results are also supported by base effects as last years’ relentless fall in commodity prices reverses. These effects, however, will fade towards early next year as the outlook for oil in particular remains murky. That said, the outlook for earnings growth both this year and next remains stable and at impressive levels, although growth in 2018 is likely to fall shy of this year’s strong performance.
 
Meanwhile, the Q3 reporting season is nearing an end and US companies have managed to yet again beat estimates. Nonetheless, this season is falling shy of the previous two this year, where already-high expectations were beaten handsomely. As Q3 was always going to be weaker in terms of year-on-year growth, we will not read too much into this. Moreover, the outlook for the coming quarters extending into next year remains buoyant.

All in all, corporate earnings keep growing at rates very supportive of risk-taking, making us comfortable with our overweight recommendation for equities.
 
Central banks to wean markets off stimulus slowly but surely
 
The monetary policy outlook remains relatively benign. Although central banks in the US, Europe and to a limited extent even in Japan are slowly ‘normalising’, monetary conditions will still remain easy in the near future. Puzzlingly, inflation in developed economies, the UK aside, does not seem to be picking up, providing central banks with a conundrum as unemployment keeps falling.
 
The Federal Reserve (Fed) in the US is the furthest along when it comes to ‘normalisation’, with the process of tapering its balance sheet set in motion in October, accompanied by a moderate pace of rate hikes. While there are certain unknowns related to unwinding liquidity from the markets, Fed Chair Janet Yellen’s reference to the process as ‘the policy equivalent of watching paint dry’ is probably not far off from what investors will experience.
 
In Europe, the European Central Bank (ECB) managed yet again to put a dovish tone on tapering its quantitative easing programme, and interest rate increases are still nowhere in sight. This, like the Fed’s tightening, is unlikely to prove a problem for risky assets. In fact, if anything, the combined impact of the resynchronisation of central bank policies between Europe and the US is likely to hamper the performance of low-risk bonds, further supporting the relative outlook of equities.
 
In the emerging countries, monetary policy remains on the easy side. Asian central banks are mainly on hold, with the Chinese authorities tightening regulation and thereby tightening financial conditions, and at the same time adjusting reserve ratios in order to increase liquidity. In the majority of the remaining emerging economies, easing cycles are still intact, meaning that the likes of Brazil and Russia are lowering their policy rates as inflation continues to slow down.
 
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 and Energy, 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 continued 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 in historical comparison, and riskless rates still hover near record lows with risks tilted to the upside, equities remain unmatched in terms of risk/return outlook.
 
Sentiment a short-term negative
 
Investor sentiment has clearly become more bullish in the past two months. In contrast to the late summer ‘fear-of-everything’ sense in the markets, investors’ mind-sets have become considerably more too sanguine recently. Equity overweights are above the historical average, cash allocations have fallen, speculative positioning is currently favouring stocks, and a large share of retail investors are expecting higher equity prices in the future. While this will not impede markets from rallying further, it does likely mean that the steepest gains from this rally are behind us. In other words, the tailwind provided by exaggerated negativity during late summer has begun to fade. Hence, while we do expect risky assets to do well going forward, the time is ripe for moderating our equity overweight.
 
Politics continue to create noise
 
Investors are clearly placing more scrutiny on the political environment than they have in recent years. However, although early-morning tweets from Washington and sabre-rattling with North Korea continue to create headlines, they will not cause material market movements, barring a serious escalation.

The talk of tax reform – or cuts, to be precise – in the US has already lifted risky assets somewhat. While some form of tax cuts can be expected, they will likely fall far short of what the Trump administration has promised and should not be expected anytime soon. Nevertheless, we expect some positive impact on the economy and earnings eventually.

Moving to China, the five-yearly Party Congress concluded with a number of new faces in the Communist Party Standing Committee. While there are hints that Xi may extend his rule beyond the customary limit of two terms, this is currently no cause of concern for investors, considering his record on pushing forward on important, market-friendly reforms.

Finally, in Europe, the Catalan situation has flared up again. While it is the worst political crisis of Spain’s 40-year-old democracy, the market implications are much more muted than the headlines suggest. Markets on a European level have barely reacted to the developments; it appears to be largely contained to Spanish assets. As the situation evolves, we expect the December snap elections to take precedence over the fight for independence. This also means that while we will continue to see headlines, markets are likely to fade the issue.
 
In conclusion, then, the investment outlook is supportive for risk-taking. We remain in something of a sweet spot for risky 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.