While we believe the fundamental environment remains sound, it’s not improving. As risks are rising, prudent investors may want to consider the merits of positioning portfolios more conservatively, at least at the margin. Though we don’t think a recession or bear market is imminent, returns going forward may be more muted than they have been over the last couple of years.
The synchronised global economic expansion that powered earnings growth in 2017 appeared to have plenty of steam coming into 2018. However, some indicators pointed to slowing momentum, especially in Europe and Japan.
NAVIGATING THE MID-CYCLE PAUSE
As we enter the second half of 2018, some indicators point to slowing momentum – especially in Europe and Japan (Figure 1). However, it would be a mistake to assume that because the current expansion has been long (nine years and counting) it must be nearing its end.
Rather, we may be at a mid-cycle pause, as central banks around the world recalibrate monetary policy for a more sustainable economic expansion.
- The growth outlook appears most robust in the US. Confidence remains high and last year’s tax cuts continue to put disposable income in the pockets of consumers and corporations.
- European economies also look broadly positive (except in the UK, where Brexit uncertainties continue to weigh on business confidence and investment).
- Although corporate governance reforms are improving Japan’s longer-term economic prospects, in the short run Japanese growth will depend heavily on demand for the country’s exports.
- China has largely been successful in sustaining economic growth, despite Beijing’s efforts to restrain credit expansion and restructure older industries, although momentum could slow in 2018.
Figure 1: The Synchronised Global Recovery Continued in the First Half
Purchasing Manager Composite Indexes
Average Monthly Levels, as of May 31, 2018
United States is represented by the S&P 500 Index. Other countries/regions represented by their corresponding MSCI Index.
Sources: Haver Analytics [Markit], FactSet Research Systems Inc. All rights reserved.
HAS EARNINGS GROWTH MOMENTUM PEAKED?
US earnings growth accelerated in the first quarter and although earnings momentum slowed somewhat in Japan, Europe and the emerging markets, underlying trends appear positive (Figure 2). Even if earnings growth moderates over the reminder of 2018, we do not expect a sharp slowdown. This provides a reasonably constructive environment for equities.
Figure 2: Earnings Momentum May Be Peaking But Growth Remains Strong
Regional Earnings Per Share, as of May 31, 2018
Sources: FactSet Research Systems Inc. All rights reserved.
HEADWINDS ON THE HORIZON
We see three potential headwinds for markets in the second half: rising rates, a stronger dollar, and geopolitical risk.
- Strong US growth, low unemployment and expectations of future Fed rate hikescombined to push Treasury yields sharply higher in the first half of the year. While this is typically bad for economic growth and equity returns, we think underlying earnings growth will trump higher rates.For now, the US and other developed markets continue to benefit from a relatively benign inflation environment. This should allow the Fed to remain on a gradual policy course, avoiding the kind of sudden or large rate hikes that might lead to a market dislocation.
- Emerging markets, however, could be more at risk due to thestrengthening dollar. The potential for financial contagion can’t be dismissed, particularly among countries that have made less progress in curbing chronic budget and current account deficits.
- Geopolitical risk remains a catalyst for market volatility in the shorter term. We witnessed this in February, when the prospect of US tariff hikes contributed to a global selloff. Further populist or protectionist policies, particularly those that could spark a US-China trade war, could do significant global economic damage.
STRATEGIC INVESTING MORE CRITICAL THAN EVER
Most global asset classes appear quite expensive relative to their longer-term averages – averages which themselves have been pulled higher by the equity and bond price gains seen since the global financial crisis.
With global equity markets generally moving sideways in the first half of 2018 despite strong earnings growth, price/earnings (P/E) multiples slipped from their late 2017 peaks. However, higher US interest rates and bond yields eroded the support that extremely low rates have provided for equity valuations since the financial crisis.
Markets are now strongly divided between companies that can demonstrate structural growth and companies that are structurally challenged, meaning aggregate valuations are perhaps less meaningful than they once were.
In this environment, security selection is more important than ever.
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