Schroders Keith Wade & Aymeric Forest look at whether equities can sustain their stellar run in view of the coming reduction in central bank liquidity, geopolitical tensions, currency moves and stretched valuations?
Equities underpinned by solid synchronised global growth
The global economy is on a firm and synchronised upward trajectory, which is increasingly industrial-led and underpinned by a synchronised recovery in trade. Recent data from exporter regions has underlined this.
Equity markets have clearly benefited with valuations reaching lofty levels, but for the foreseeable future there should be sufficient positive momentum to bring more gains. Whether this upswing is yet on a self-sustaining footing, however, is a more open question and one addressed by our panel.
“All data is coming in very strong at the moment and we’re really seeing this synchronised recovery take hold,” said Keith Wade, Chief Economist. “This ties in with a synchronised recovery in trade. It’s good for Asia and generally good for emerging markets (EM).”
Aymeric Forest, Head of Global Income, Multi-Asset Investments said: “Equities have benefited from the global synchronised upswing and have come out of a period of earnings recession. We are also seeing a synchronisation of earnings growth.”
“We are in stretched valuation territory but not extremely,” he said, adding that earnings growth has been strong. “At the moment, we would see any correction as a buying opportunity.”
Forest argues that a V-shaped recovery following an earnings recession is normal. He anticipates earnings growth of 8-12% supporting gains in 2018, but a smaller expansion in price-to-earnings ratios. (This is a ratio used to value a company’s shares. It is calculated by dividing the current market price by the earnings per share).
Further stimulus required
On a longer-term view though, markets and the economy are entering a phase which will see a number of perhaps defining questions brought to bear. The panel agreed for instance that fiscal stimulus is likely to be required to sustain economic momentum.
“We see the US economy as more of a 2% economy in terms of trend,” said Wade. “There’s a shift away from consumer towards capex. That will carry the economy forward, but there would need to be some stimulus to get it back to 3%.”
Forest sees further stimulus as crucial, for equities as much as the economy, predicating his positive 12 month outlook on expectations of fiscal loosening. He thinks the market is too preoccupied with the US and that fiscal stimulus across the globe is key.
“As valuations are becoming less appealing, the focus will be on growth,” said Forest. “It’s the idea of keeping this cycle going, which has been long in relation to history. To break hurdles going forward will be more and more challenging.”
“The focus and need for stimulus is global, not only in the US. For next year we expect balance sheets to expand, but at a much slower pace than this year and with potentially a negative rate of growth from 2019,” he says.
Forest acknowledges there is a lot riding on the next 12 months in terms of shaping the longer-term path for equities. With ultra-accommodative policy coming to an end, what companies and governments do on the ground will be increasingly important.
“In a year’s time we will have a bit more feedback on what has been achieved on the fiscal side and will see where we are in terms of capex and maintaining earnings growth,” said Forest.
A possible headwind to the economy comes in the form of geopolitical tensions, between the US and North Korea especially, and regional political unrest.
The more immediate implication of US-North Korea tensions, Wade suggests, would be more protectionist measures between the US and China. This could occur as a result of US frustration with China’s apparent failure to uphold its end of an agreement to contain North Korea.
In Europe, unrest in the Spanish region of Catalonia, which represents 20% of the country’s GDP, will likely hit the economy and may have wider implications.
Wade said: “There is the potential for other independence movements around Europe to come forward and that could cause quite a pause in economic activity.”
Forest sees the near-term volatility as an opportunity, however, with any further outbreaks of unrest potentially adding pressure on governments to provide fiscal support.
“It would be difficult for the EU to enforce fiscal rules against this backdrop in Spain,” Wade said. “I think they will allow some loosening.”
Catalonia also raises the spectre of renewed fears concerning the eurozone periphery particularly as the European Central Bank (ECB) moves to taper quantitative easing (QE).
Wade warned: “One of the things we are thinking about for 2018 is what will happen to peripheral risk when you take away that buying. Do you see spreads widen out or a return of some of the problems of three or four years ago?”
With the selloff in the US dollar, the appreciation of the euro and the recent rush for the safety of the Japanese yen, currency is again a key risk for investors.
“Going into 2018 this is going to be critical, if we see a stabilisation or a short-term correction of the euro or yen it will help to boost earnings expectations,” said Forest. “Currency will be critical for regional equity allocation.”
Indeed, according to Forest, current levels suggest the euro and dollar moves may have largely played out, with $1.20 an accurate reflection of the euro’s long term fair value.
“To go beyond that you need a drastic change in monetary policy or clear divergence in economic growth in the US and Europe, which is unlikely.”
Another facet to currency moves has been their influence on central banks. “The Bank of England (BoE) is under pressure because of the weak sterling and the ECB wants to start its exit strategy but has seen tightening as a result of euro strength,” said Forest.
Wade added: “The BoE has been unhappy about the effect of the weak pound on the economy. It has boosted inflation, but it hasn’t boosted trade at all, net exports are still dragging on the economy.” He expects the BoE to look through fundamentals and hike rates in November.
The above article was first published by Schroders on 9th October 2017