Global Market Outlook 2017 mid-year update: Late-cycle lean out
It’s time for our mid-year update to our 2017 Global Market Outlook. And the short story is that we’re not changing many of our views from our annual outlook. We still believe in buying dips and selling rallies against a backdrop of an expensive U.S. equity market. We see an earnings outlook that looks broadly neutral. And we see overall sentiment indicators that point to complacency. We believe Europe is in a better position within its market cycle and, to a lesser extent, feel the same about Japan and emerging markets. We think government bonds are expensive, but a lack of global inflation pressure should keep yields in range.
U.S. economic overview
If we take a closer look at the U.S., last quarter our strategists cautioned that investors were becoming over-optimistic about near-term U.S. growth prospects. Disappointment seemed likely, creating the potential for market volatility. Sure enough, the U.S. economic data subsequently began to disappoint. One interesting data point is the Citigroup economic surprise index, which tracks U.S. economic data releases against consensus forecasts from economists. This index plunged from plus-60 in mid-March to minus-80 in late June.
We believe that shift from positive to negative economic surprise triggered a 45-basis point decline in the 10-year Treasury yield and a 5% fall in the U.S. dollar index. But, that said, the negative economic shift hasn’t yet generated a meaningful pullback in U.S. equities.
U.S. equities: Cycle, value and sentiment
But we are keeping a close eye on the U.S. equity market sector, as our cycle, value, and sentiment process tells us to be cautious. Expensive valuation implies a kind of dangerous asymmetry in the return outlook, where the potential downside is larger than the upside.
For now, the absence of significant U.S. recession risk means the cycle is broadly neutral for equities. This stops us from being too bearish. Overbought sentiment stops us from chasing the current momentum-driven rally. So, as we said, we want to lighten up in the current rally and look to buy the next dip.
Three key indicators
Our 2017 annual outlook report listed three indicators we would watch closely in 2017: U.S. wage measures, fiscal policy announcements and emerging markets exports.
- U.S. wage growth has moved sideways this year, despite the unemployment rate declining to 4.3% in May. This is reducing the pressure on the U.S. Federal Reserve to lift interest rates, so we expect them to hold steady for the rest of 2017.
- Fiscal policy is providing a modest boost to growth this year, but recent news is mixed. President Trump’s plan for tax cuts and infrastructure spending looks likely to be delayed until 2018 and his slim Senate majority means that stimulus is likely to be modest. In Europe, newly elected President Macron in France is promising fiscal restraint. By contrast, the U.K.’s conservative government is planning to ease back on fiscal austerity after nearly losing the recent general election.
- Emerging markets exports remain robust, but there are tentative signs of a peak.
These three indicators combined point to an easing of U.S. inflation pressures, a still modest boost from fiscal policy and continuing strength in global trade.
Global equities: Cycle, value and sentiment
It’s a mixed cycle outlook for global equities. Cycle tailwinds for equities are strongest in Europe, followed by emerging markets and Japan. In the U.S., our cycle score is neutral. Economic growth is near trend and corporate earnings growth is limited by high margins and a lack of pricing power. U.S. tax cuts and infrastructure spending could provide a fiscal policy boost, but if enacted, are likely to offset by further tightening by the Fed.
Regarding value, we believe U.S. equities are very expensive. The Shiller price-to-earnings ratio uses the 10-year average of inflation-adjusted earnings. And it’s the highest it’s been outside of 1929 and the late-1990s Internet bubble. In comparison, European equities have moved to just slightly expensive after their recent run. We think Japan equities are around fair value and emerging markets are still reasonably cheap.
If we switch over to sentiment for global equities, we see that price momentum is positive across all regional markets. But a range of indicators still suggests that markets are overbought and actually pretty complacent. The most prominent contrarian indicator is the CBOE Volatility Index—The VIX—otherwise known as the fear index. The VIX has fallen to levels last seen in 2006.
So we’re still cautious on the near-term outlook for global equities, and if we haven’t made this clear by now, we see the expensive U.S. market as the most vulnerable.
Treasuries: Cycle, value and sentiment
If we move over to treasuries globally, we believe they are still expensive in nearly all regions. They’re closest to our fair value estimate in the U.S. and furthest from fair value in Germany and the U.K.
The main change is that the cycle view for U.S. Treasuries has moved from negative to broadly neutral. Economic disappointment, the stalling in wage acceleration and the lack of pricing power have generated some dis-inflationary forces in the U.S. economy. And those forces look likely to stick around for the next few quarters.
Cyclical forces look broadly neutral in Japan and the eurozone. For example, the Bank of Japan recently reaffirmed its policy of targeting a zero-percent 10-year bond yield. The European Central Bank has signaled that it will continue with negative rates until at least the end of 2017. UK gilts have a slightly negative cycle, where the large post-Brexit referendum sterling devaluation is pushing up inflation.
Around the world, our sentiment indicators for treasuries are mostly neutral, save for the U.S. being slightly overbought after the recent rally. Broadly, our process points to yields remaining in a range for the next few months, but expensive valuation means the medium-term trend is upwards.
In summary, we believe the challenge for the rest of 2017 is that we’re in a late cycle-momentum-driven market. Valuation is at an extreme—particularly for U.S. equities. We recognize that momentum can drive markets beyond fundamentals—for a while. And no investment process is going to pick the exact peak in the cycle. But we believe investors should lean out as the risks increase.