Risk assets produced a mixed performance regionally in July. Helped by a weaker dollar, the S&P 500 gained 47 to 2,470 with the Dow Jones Industrial breaking through 22,000 in early August. The FTSE100 rose 59 to 7,372 while there was an even stronger upward move by the more domestically orientated FTSE250 mid-cap index. Despite both UK indices closing below their end-May highs, year-to-date total returns (including income) were 5% and 11% respectively. Asian and emerging markets made the best gains over the month and year-to-date as high GDP growth, increased global trade and cheap valuations attracted international investors. Although the Eurozone and Japan have been performing well, they lost some ground in July with the FTSEurofirst 100 down 7 at 1,484 and the Nikkei 225 falling 108 to 19,925. Boosted by demand from China, commodity prices have improved and oil rose over 8% to $51. Returns from conventional bonds were marginally positive, corporate spreads narrowed and high yield and emerging market debt out-performed.
Against this background and very low volatility, investors are understandably questioning whether to take profits and look at alternatives to equities. As always, there is no simple answer but it is important to bear in mind that the devaluation of sterling following the EU referendum has resulted in exceptional returns for UK portfolios with international exposure and this is unlikely to be repeated. For global investors portfolios have also gained but not to the same extent. When an economic cycle approaches a peak, the classic trade is to retreat to short-dated fixed interest stocks because – even if central banks raise interest rates – they are close to redemption value and, in the case of government debt, this is guaranteed. While this broad principle still applies, the key factor this time is their abnormally low income returns hold little attraction for income-dependent investors accustomed to 2%-3% dividend yields on equities. This means a choice has to be made between return of capital or return on capital (while accepting the associated risks) with the balance reflecting individual circumstances and preferences.
Market indices in isolation do not provide a reliable guide. Valuations are more important and, with corporate profitability supporting current levels, the outlook still appears reasonable. Although towards the upper end of their ‘normal’ historic range, valuations are by no means extreme particularly as the reporting season has shown that profits growth is now being driven by revenue gains and not just by cost cutting. At the margin, revisions to earnings have picked up in the US but rolled over in the Eurozone and Japan – possibly reflecting the euro’s 12% rise this year against the dollar. Eurozone markets still look relatively cheap on a prospective 15x valuation compared with 18x for the US and 16x for the FTSE World index. Leaving aside the possibility of companies embarking on a debt-fuelled takeover spree, we have to look elsewhere to identify potential risks such as the cost and availability of capital, economic growth and policy initiatives which could impact corporate taxation and trade.
Attention is mainly focused on monetary policy and growth as these tend to be more transparent. The recent soft inflation data – largely resulting from the year-on-year fall in oil prices – means expectations of rising interest rates have eased a little. However, after five years of economic volatility, developed and emerging economies are both now growing steadily and unemployment is falling. Although inflation remains below the targets set by many central banks, their policy is still a gradual withdrawal of monetary stimulus. As this is more likely to be achieved by shrinking balance sheets – ending or scaling back asset purchases and effectively retiring the money ‘printed’ – than interest rate rises, it offers little relief for hard-pressed savers. However, ‘quantitative squeezing’ has never been tried before so, as with the easing during the financial crisis, there could be unintended consequences. The Federal Reserve will announce details in September but the European Central Bank is of more concern given its track record on decision-making and the fact that its asset purchase programme has caused greater distortions. The Bank of England probably occupies the middle ground in that quantitative easing has distorted its balance sheet but asset purchases have been counter-balanced by the extended issuance of long-dated gilts. This has bought some breathing space as long as global interest rates do not rise unexpectedly in the meantime. The Bank of Japan has the least economic justification for scaling back monetary easing but Prime Minister Abe’s position has been severely weakened by the LDP’s defeat in the Tokyo elections. Any policy changes are likely to impact the Nikkei-linked ETF asset purchases rather than the 0% yield target on 10 year JGB government bonds.
The economic growth outlook is probably the least of investors’ worries although the UK clearly has some self-inflicted domestic difficulties as sterling weakness squeezes real disposable incomes, consumer debt is rising and the savings ratio is at a historic low. While recent economic data has contained few upside surprises, this partly reflects the unwinding of Trump post-election boom expectations. In reality, growth has been broad-based and is accelerating in both developed and emerging economies for the first time since 2010. Forecasts are being revised up albeit modestly and predominately for the developed world. The global economy appears on track for GDP growth of 3.1% this year and 3.3% in 2018. Developed economy growth is expected to be just over 2% led by Spain, Ireland and Canada with the US and Eurozone around the average. Japan and the UK are likely to lag with UK growth falling from 1.7% in 2017 to 1.5% in subsequent years during the Brexit ‘transition’. Globalisation and more flexible labour practices mean wage inflation is dormant and CPI in the developed world is expected to undershoot central bank forecasts and remain below 2% for the next five years. The exception is the UK where inflation is unlikely to peak until the end of this year as the impact of sterling devaluation starts to unwind.
The combination of synchronised global growth, sluggish inflation, accommodative monetary policy and strong corporate earnings should continue to underpin global equity markets. Although year-on-year returns are unlikely to be repeated, they should still exceed those on bonds where we see yields range bound for the time being. As companies generate higher profits, this will support dividends and the return of excess capital to shareholders.
