The post-2008 global economic and financial market landscape has been characterised by sluggish, yet remarkably steady, economic activity levels and mixed corporate earnings delivery. In this environment, much of the realised equity market returns have been driven by so-called earnings multiple expansion, as equity investors become willing to pay an ever increasing multiple of future earnings.
What was the cause of this?
Within developed economies, central banks have continued down the path of super accommodative monetary policy, with interest rates maintained near zero – or even negative in some cases – and their respective balance sheets swelled by substantial bond-buying programmes. Taken together, this central bank activity comprises a form of financial repression, sucking yield of interest-bearing securities and making other asset classes, in particular equities, look relatively more attractive.
Within equity markets, the preferences of investors have clearly been influenced by this background. Companies able to grow their earnings at an above-average rate – growth stocks – have been sought after, as have firms able to pay an attractive and well-covered dividend – defensive stocks. Less highly rated equities and those more geared to the economic cycle have tended to lag – at least until the past few months. What has changed?
Developed market central banks are, in a careful and measured way, likely to wean the financial markets off the world of easy money during the next 12 to 18 monthsThis year has seen global growth break out of the range to which it has been confined since 2010. In addition, we have had a similarly impressive delivery of corporate earnings. Taken together, these factors support the view that this year’s rally in global equities is “fundamental” rather than a function of central bank policy.
The drivers of this much-improved economic and financial market landscape are several:
- an improvement in the prospects for the emerging economies that has boosted the commodity, manufacturing and global trade cycles;
- highly accommodative monetary policy in Japan and the eurozone finally delivering above trend growth, and;
- a long overdue pickup in business investment as corporates finally turn their back on their earlier caution in favour of a more optimistic stance.
There are a number of observations we can make about this changing regime. The first is that we are seeing a reflexively positive relationship between strong global growth and corporate revenue growth, with corporate earnings further boosted by a pick-up in margins as corporate pricing power returns. Elsewhere, the rally in global asset markets has generated a tailwind for growth.
But perhaps the most important point to make is that developed market central banks are, in a careful and measured way, likely to wean the financial markets off the world of easy money during the next 12 to 18 months.
Key Points
- Investors have been influenced by earnings multiple expansion.
- There is a positive relationship between strong global growth and corporate revenue growth.
- 2018 is expected to be a more challenging year for fixed income.
In terms of investor preferences, there has been shift towards favouring sectors that benefit from an improving cyclical outlook – notably technology, financials, industrials and emerging markets.
What else has changed? We have seen a significant reduction in the correlations between different asset classes and a much wider dispersion of returns within individual equity markets. This suggests central banks may be beginning to have a waning effect on financial markets. This is welcome because it gives investors something that is prized when constructing portfolios – increased diversification.
The pessimists would argue that all this is well and good but that this environment will presage the next economic and financial market downturn. In particular, they highlight that the economic expansion seen since 2009 is long by historical standards and that a recession is on the horizon. Optimists contend that investment cycles end through economic and financial market overheating and would cite the generally below-target inflation in the developed world and relatively low levels of financial market leverage to argue that we can run somewhat further.
We are cognisant of a number of risks as we head into 2018: policy error on the part of central banks as they further withdraw stimulus, a hard landing in China caused by an unwinding of the credit cycle and host of potential adverse global geopolitical developments. However, we tend to side with the optimists, anticipating the dual tailwinds of good global economic and corporate earnings growth to outweigh concerns over the potential end of easy money.
In general, we expect earnings to drive regional equity returns and this leads us to overweight Asia, Japan, US and eurozone, against an underweight in the UK and Latin America.
Elsewhere, we do expect a more challenging year for fixed income given the current low level of yields and tightness of credit spreads and we continue to underweight bonds to fund an overweight in equities.
We do not, however, expect a substantial and sustained rise in bond yields this year, but we do recognise that were this to happen – for example on the back of a much more rapid increase in inflation – the knee jerk reaction could be for a decline in equity earnings multiples and weaker stock markets.
This highlights the importance of central bank guidance and underlines the potential sensitivity of financial markets to the withdrawal of central bank stimulus.
Finally, in terms of currency, we think sterling will sit in the middle of the pack, outperforming the yen and the euro, which we expect to be hampered by negative yields and ongoing quantitative easing, and underperforming the US dollar and emerging market currencies on less favourable growth and interest rate differentials.
Jon Cunliffe is chief investment officer of Charles Stanley
