Tensions between profits and politics
As long as trade tensions die down, then investors should turn their attention back to favourable corporate fundamentals.
Pricing in the progression of profits
The first few months of 2018 have shown the difficulties equity investors have in pricing in future profits growth in a fast-changing environment. On a positive note, economic forecasts for the world economy are being raised for 2018 and 2019, while the conditions are falling into place for a robust period of corporate profits growth (see Chart 1). This helps explain the extent of the rise in share prices in January and the continued low levels of corporate bond spreads into the spring. On a more negative tack, politicians in the US, Europe and China have opened up two new policy fronts – a variety of trade skirmishes and sanctions, and questions about the degree of regulation covering parts of the technology sector. Both could develop in a multiplicity of ways in coming months. Therefore, it is no surprise that recent surveys of investor confidence have indicated a less pronounced level of optimism and that cross-border capital flows show classic signs of risk aversion in recent weeks: out of equities into fixed income, out of high-yield debt into investment-grade corporate and government bonds. The key questions facing asset allocators are whether to hold firm with a pro-risk stance, despite more volatile times, and what the leadership of the next phase of the cycle might look like?
The first quarter is often weak – the rest of 2018 will be better
Before discussing trade and regulation, it should be noted that the economic data for the first quarter have also been on the weak side, which has further encouraged some profit taking. Europe has led the way; however, business optimism in both Asia/China and North America has cooled. Using the US economy as a global proxy, GDP growth in the first quarter looks on course for about 2% on a quarter-on-quarter annualised basis. Two points should be made; first, after very strong co-ordinated growth in the fourth quarter of 2017, it is no surprise to see activity rolling over in various parts of the world, especially when winter weather and poor seasonal adjustment complicates analysis. Second, it should be emphasised that business surveys are still in line with decent growth in the first half of 2018 (see Chart 2), while looking ahead the major fiscal stimulus in the US will increasingly feed into stronger US activity and, via trade flows, stimulate other economies too.
We still consider the underlying economic backdrop to be supportive of risk taking. Global economic growth in 2018 and 2019 looks to be either at or above trend, leading to a moderate rise in consumer prices plus pockets of inflation pressure (both wage and non-wage driven) bubbling up. Activity in developed economies should be more robust than in emerging economies, supported in particular by much easier fiscal policy and steady but not aggressive monetary tightening in the US. Inflation trends remain the key risk for investors to monitor.
Accordingly, the outlook for corporate profits growth looks solid for 2018 and 2019, with pressures on company margins expected to be manageable. This partly reflects the benefits of tax cuts and productivity growth in the US, partly the lack of wages pressure in other developed and emerging economies. The first quarter earnings season in the US is on course for corporate profits growing 10-12% from a year earlier; this excludes the benefits of the US tax cuts which should add another 6-8% to earnings as the S&P 500’s effective tax rate is projected to fall from 27% to 22%. It should be noted that part of the benefits of the changes to the US tax code assist companies headquartered in other countries that have US operations. Surveys suggest that one of the benefits will be sharply higher levels of share buybacks as well as increased levels of M&A activity in coming months. Cash sitting on European and US balance sheets remains near record highs.
At this point, sectoral analysis is important to help determine the leadership of the next phase of the cycle. This examination is also crucial in light of the recent rhetoric from the White House and communications from the European Commission about tightening regulation on parts of the technology sector, especially in relation to social media and privacy. There is a risk that such political activity affects the share prices of individual stocks, including some of the larger weighted constituents of the indices. However, our analysis suggests that, despite recent concerns, trends for this group of companies remain intact, and the sector remains a standout on both top and bottom-line growth. As an example, progress towards e-commerce away from traditional high street/shopping mall retail outlets is far from complete in most countries.
Our expectations for other sectors stem from our core economic forecasts. Above-trend growth and moderate upward pressures on inflation would support a steeper yield curve, and hence outperformance by financials, again assisted by lower tax rates. Similarly, the conditions look to be in place for a pick-up in commodity prices, helping energy and materials stocks. Last of all, an upturn in capital spending financed in part by changes to the US tax code will also help cyclical stocks more generally. All in all, first quarter earnings growth will be an important litmus test in encouraging investors to turn their focus back towards corporate fundamentals.
Trade tensions tit for tat
A key assumption about our current portfolio positions is that a trade war is averted, even if skirmishes last some time and add to daily market volatility. Financial markets often find it difficult to price in political news, especially when the topics are new, even more so when previous rules of engagement between countries no longer work. The US government has given very mixed signals to investors, from President Trump’s tweets about tariffs to more reassuring statements from other parts of the Administration and reports about the US re-joining the Trans-Pacific Partnership. At face value, the sums involved in tariffs are still too small to have a major effect on economic forecasts for either the US or China. However, equity markets have clearly looked further ahead, encouraged by media commentary about imminent trade wars, rather than stepping back and trying to understand the more likely path of a negotiating process which will (hopefully) end up as win-win rather than lose-lose for both sides.
Other political issues should not be ignored. At the time of writing, there is more positive news about a potential US-North Korean summit, but more worrying news from Syria, and Italy where a populist anti-EU government might be formed. Trump’s populist rhetoric is likely to increase in the run up to the mid-term elections in November. At a time of greater risk aversion, it would be no surprise if periodically such factors drive cross-border capital flows into safe-haven assets. The good news remains that so far these political shocks look to be contained, rather than triggering major second round or knock-on effects.
At the end of January, there were many concerns that share prices were over-valued. That argument is not as persuasive after recent price declines; for example, in March the S&P 500 forward price-to-earnings ratio fell to just 16x, its lowest level in over two years (see Chart 3). On some valuation metrics the important technology sector now trades at a discount to its history. Our technical analysis is also useful in this regard; work on the type of equity market regime and a timing indicator framework using such inputs as liquidity and macro-momentum are in line with a risk-on rather than a risk-off backdrop for the next few quarters, albeit giving some early warning signs on a two-to-three year basis. Aggressive policy from the Federal Reserve and an end to the US fiscal stimulus in 2020 could be one cause. Taking these factors into account, equities can keep making new highs but with increased volatility.
Accordingly, we continue to hold an overweight position in global equities, led by emerging Asia, then Europe, Japan and the US, with developed Asian equities as neutral to take account of China policy risks. The UK stockmarket has a neutral-to-underweight position; it has materially underperformed in recent months, which we assess is due to a mixture of sector weightings, company specific issues, and the impact of sterling’s appreciation as Brexit fears are discounted. Value requires some strong triggers to cause a turnaround in performance.
In other asset classes, we remain neutral-to-underweight in most fixed income markets. Valuations are not supportive when headline inflation causes negative real yields in many markets. We continue to prefer parts of the higher yielding markets, such as local currency emerging market bonds and US high-yield bonds, although in both cases the weight of money entering the market is restraining cash yields. These positions are funded by our underweight in key markets, such as low yielding Japanese government bonds. Yields, valuations and low levels of new supply bolster an overweight position in commercial real estate markets in Europe.
One of the key signals from our recent Quarterly Global Investment Group was that although the current portfolio is risk-on, there are a number of events or outcomes which could swiftly discourage risk taking by investors; geopolitics and policy errors are obvious examples. Hence, we are looking for more diversifiers. In this portfolio, examples would include the preference for global relative to UK equities, a yen position to benefit from safe-haven flows when these appear, or inflation-linked bonds in case of an upside inflation surprise. Our other currency positions are broadly neutral on the basis of fair-value estimates.
View the full Global Outlook publication below:
- Tensions between profits and politics
- Scenarios to spoil Goldilocks’ porridge
- Angels and ABSolute returns
- Multi-speed inflation
- The importance of solving a global low-cost housing problem
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