Investment strategy outlook
Undue pessimism about global growth has given way to excessive optimism. Equity markets are overbought, and a correction, in our view, should create a buying opportunity. U.S. Treasuries are now fairly valued at around 2.5%, but we expect yields will be under upward pressure from rising inflation and Fed tightening.
The fake news rally
It doesn’t seem long ago that investors were worried about secular stagnation — the idea that growth would remain disappointing, inflation would stay low and central banks would maintain extremely easy policy settings. Now, in early 2017, the buzzword is “reflation” as global economic growth exceeds forecasts, inflation edges higher, and the U.S. Federal Reserve warns of a faster pace of rate rises.
The earlier pessimism turned out to be unwarranted, and we believe the current optimism will prove likewise. It’s true that global growth has picked up, but not by enough to justify the optimism priced into the S&P 500. We still see plenty of headwinds for the global economy, not least Fed tightening and a slowing Chinese economy.
Equity markets are deeply overbought and a pullback seems likely once overinflated expectations are confronted with the more pedestrian reality. We see places where more optimism is justified, such as Europe and, to a lesser extent, Japan. However, in our view, markets are overestimating the ability of President Trump to boost the U.S. economy and forgetting that the U.S. economy is near full capacity. This means that any Trump stimulus is likely to be offset by a more aggressive Fed to contain inflation pressures.
We’re still in a “buy the dips and sell the rallies” market environment in early 2017. We want to sell the current rally and look to buy the next dip.
Key indicators update
Our 2017 annual outlook report in mid-December listed three indicators we would watch closely in 2017: U.S. wage measures, fiscal policy announcements and emerging markets exports.
- U.S. wages are tracking higher as the unemployment rate settles below 5%. We believe the trend in the Atlanta Fed’s wage growth tracker will keep the Fed under pressure to continue lifting interest rates.
- Fiscal policy looks less supportive for global growth. President Trump has talked up federal tax cuts and infrastructure spending. However, his slim Senate majority means that stimulus is likely to be modest and delayed until 2018. Japan and the UK are continuing with fiscal consolidation. Fiscal trends are more positive in Europe, where elections are pushing governments to open their purse strings.
- Emerging markets (EM) exports continue to strengthen. The bellwether market of South Korea is experiencing its fastest export growth in five years.
The economic indicators we watch point to U.S. inflation pressures and Fed tightening, a smaller boost from fiscal policy (apart from in Europe) and a continuing recovery in global trade.
U.S. hourly earnings & unemployment rate
Source: Thomson Reuters Datastream, last observations: January 2017 (wage tracker) and February 2017 (unemployment rate).
Global equities: cycle, value, sentiment
Our investment process is based on the building blocks of business cycle, value and sentiment, and here’s how we see it at the beginning of the second quarter of 2017:
- Business cycle: It’s a mixed cycle outlook for global equities, and tailwinds for equities in our view appear strongest in Europe, followed by Japan. The U.S. cycle score is neutral. Growth might have improved, but this is offset by potential Fed tightening. The cycle has improved to neutral for emerging markets as growth indicators pick up, but EM is still vulnerable to Fed rate hikes and further USD strength.
- Valuation: U.S. equities are very expensive. The Shiller P/E ratio, which uses the 10-year average of inflation-adjusted earnings, is the highest it’s been outside of 1929 and the late-1990s Internet bubble. European and Japan equities are around fair value, in our view, while emerging markets are still reasonably cheap.
- Sentiment: This combines price momentum with indicators that signal whether markets are overbought or oversold. Price momentum has picked up strongly over the past few months, but simultaneously nearly all our overbought indicators have been triggered. The U.S. appears the most overbought with a range of technical indicators pointing to a stretched market and investor-confidence survey indicators suggesting widespread overconfidence.
- Conclusion: We’re cautious on the near-term outlook for global equities, viewing the expensive and overbought U.S. market as the most vulnerable. Looking further out, Europe has an attractive combination of reasonable value and good cycle support. Japan has reasonable value and emerging markets have good value.
Treasuries: The cycle is turning negative
Yields on 10-year U.S. Treasuries have lifted by around 100 basis points (bps) to 2.5% over the past nine months as of March 15, 2017. This is close to fair value based on our valuation methodology. Yields have risen by much less in Japan, the U.K. and Germany, and valuation in these markets respectively remains expensive.
There is some difference in the cycle outlook across regions. The cycle is moderately negative for the U.S., where inflation pressures are picking up and the Fed is lifting short-term rates.
The big British sterling devaluation in 2016 means that inflation pressures are also a cycle headwind for U.K. gilts. By contrast, the Bank of Japan (BoJ) seems likely to maintain its policy of targeting a 10-year bond yield of 0%. And we believe the European Central Bank should continue with negative rates and asset purchases until at least the end of 2017.
Our sentiment indicators are mostly neutral, save for the U.S. being slightly oversold after the recent large rise in yields. Broadly, our process points to yields remaining in a narrow range for the next few months, although the medium-term trend is upward.
Currencies: USD has limited upside
The U.S. trade-weighted dollar has moved in a narrow range over the past few months. Rising interest-rate differentials against other regions are dollar supportive, but this is offset, in our view, by expensive valuation.
Some analysts believe there could be a large U.S. dollar rise if the Trump administration introduces a destination-based tax system that would benefit U.S. exports and penalize imports. We’re a little skeptical about this. First, there is a lot of political opposition in the U.S. Congress to a border tax system, so it may not go ahead. Second, the USD impact of a border tax may be smaller than expected if there is trade retaliation from other countries.
The euro, Japanese yen (JPY) and British pound (GBP) have attractive valuations. But none seem likely to move significantly higher in the next few months. The yen is likely to remain under pressure from widening interest rate differentials with the U.S. The uncertainties surrounding Brexit will likely keep British sterling in its current range. The euro has some potential upside over the medium term, but political uncertainty over the French election likely will prevent any near-term appreciation.
Overshooting to the upside
Markets have reacted to better economic news and the hope that President Trump will deliver substantial tax cuts and fiscal stimulus.
Our process tells us that U.S. equities are very expensive, have only modest fundamental support from the business cycle and are significantly overbought across a range of indicators. Equities could push higher if President Trump announces large tax cuts and markets become outright euphoric.
The overbought signals drive our near-term caution. Beyond this, we like Europe’s cycle outlook and the value in emerging markets. The USD has limited upside potential, and long-term bond yields should be under upward pressure.