Written by: Paul Quinsee , Managing Director, Global Head of Equities
Themes and implications from the Global Equities Investors Quarterly
For much of the eight years that have followed the financial crisis of 2008–09, U.S. equities have considerably outpaced most global equity markets, helped by superior profit growth and the strength of the U.S. dollar. But in the past year we’ve seen signs of change. An improving global growth environment has supported the outlook for corporate profits around the world and, in turn, equity prices. As we approach 2017’s mid-year mark, the change is striking. We see evidence of broad-based growth across all regions and a raft of first quarter earnings results that affirms our view of a synchronized global recovery. Our analyst forecasts of double-digit earnings growth globally in 2017 and 2018 seem very much on track. Against that improved backdrop, we see the greatest potential in international and emerging market stocks, where valuations are less stretched and profitability gains have further room to run.
We acknowledge some caveats, of course. Higher equity valuations in the U.S., particularly for low volatility stocks, present some cause for concern, as does the economic slowdown in China. But we see a wide range of opportunities, especially in Europe and Japan, where strong and improving fundamentals paired with attractive valuations make a strong case for international equities.
In the second edition of our quarterly Global Equity Views, we examine our investment outlook, discuss market trends, highlight opportunities and consider potential risks.
Economic growth and corporate earnings
The global GDP numbers tell the story: A 5%-6% nominal GDP growth rate creates a better environment for corporate earnings. As a result of their high operating leverage, Japanese and European companies especially benefit from better nominal GDP growth.
Still, while global growth is strong and well diversified across regions, the pace of the expansion is unlikely to accelerate from here. Services purchasing managers indices (PMIs) are strong, but manufacturing PMIs, a reliable leading indicator, are off their recent peak.
On the earnings front, European companies are delivering on a long-anticipated profit recovery: Earnings are growing for the first time in six years. As of mid-June, earnings expectations are holding up at start-of-the-year levels, and we may be seeing the beginning of earnings estimate upgrades. In the first quarter, 67% of European corporates beat EPS expectations, the best showing in 14 years. What’s more, companies have been surpassing expectations on revenue growth as well, having demonstrated the strongest sales surprise since 3Q 2009.
Across emerging markets, the earnings picture is encouraging. Stabilization in currency and commodity values has benefited emerging markets, lending support to our 11% normalized EPS growth projections. After numerous years of downward revisions, our analysts’ EPS revisions have turned more positive in recent months.
In the U.S., a pickup in corporate profit growth began in the middle of 2016. So far this year, profits have continued to strengthen amid a lower U.S. dollar and an end to energy sector write-offs; the energy, financial and technology sectors have fueled the biggest gains. Although the U.S. economy is entering late cycle, we see a low risk of a recession in the near term, expecting another couple of years of solid earnings growth. U.S. stock valuations may now be higher than their long-term average in absolute terms, but they continue to look attractive relative to cash and bonds.
The MSCI Emerging Markets Index has returned almost 30% over the past year, pulling the index well above its January 2016 low. But as profits are improving and valuations continue to look reasonable, we see further gains ahead and note that the index is still about 30% lower than its 2007 peak in USD price terms. Our analyst earnings estimates imply double-digit EM equity returns propelled by stronger profits.
Many Brazilian stocks look especially attractive after two years of economic contraction and depressed equity values, especially given the sharp setback in recent weeks. Brazilian stocks recently moved back into the first quintile of our valuation ranking, a favorable tactical signal, and the breadth of earnings revisions is much wider than it has been in the past. We believe that as long as Brazil’s economic recovery persists, Brazilian companies can deliver multiple years of earnings growth.
There are some particularly striking patterns in recent EM equity performance, which have led to interesting opportunities for our investors. As the global reflation theme has faded, EM financials have underperformed, value stocks have given up all the gains they made in 2016 and commodities have surrendered all the gains they made since 2014. On the other hand, quality stocks have never been more expensive. Consequently, on a style basis we prefer value and momentum to quality in EM equities.
Our investors are finding opportunities in a wider range of European value stocks. They still like certain cyclicals (including some financials), but in the past several months their value portfolios have become more broad-based. Stocks in several sectors—pharmaceuticals, for example—are now seen as fundamentally sound and good value, whereas a few months ago many were viewed as value traps.
For U.S. equity investors, what succeeded in 2016 struggled in 2017, and vice versa. In 2016, investors rewarded low volatility and deep value stocks with no growth, but in 2017 growth has outpaced value. As our U.S. growth investors see it, the trends driving growth stocks seem sustainable, particularly given the exposure of large-cap growth to favorable international trends. For example, in the technology sector, advances in parallel processing are benefiting “rich data” companies and firms working in the artificial intelligence space. And with a few exceptions, valuations appear reasonable.
Our U.S. equity value investors are somewhat more cautious as they see some headwinds that may challenge value investing for a while. Many traditional value companies are under serious pressure from disrupters and secular changes in consumer trends, although we are looking carefully to uncover opportunities in these areas with depressed valuations. Financials remain an area of focus, especially after the sector’s recent pullback.
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Higher valuations worldwide, especially for U.S. and low volatility stocks
Rich valuations for low volatility and low beta equities have yet to be corrected. Indeed, in some instances these stocks have gotten more expensive in recent months, particularly in the U.S. These higher prices continue to pose risk for investors searching for yield in a still-low interest environment.
In China, financial sector leverage has risen steadily in the past few years, although the debt burden is not as great as it has been in past cycles and there have been limited spillover effects on non-financial institutions (such as reduced availability of bank loans). Still, the risk is growing and China’s banking regulator has moved to reduce leverage in the financial system. (We note that China is the one major economy in the world where financial re-regulation is underway.)
The coming slowdown in central bank balance sheet expansion
Our fixed income colleagues are forecasting a considerable moderation in global central bank balance sheet expansion over the next couple of years, led by the Federal Reserve, which will actually be reducing the size of its balance sheet. Markets will face the first hurdle when central banks slow down their net balance sheet expansion, which should occur sometime this year. But the very high hurdle for markets will appear in the third and fourth quarters of 2018, when the net balance sheet of global central banks will actually contract.
The consequences for equity investors are somewhat unclear. We are encouraged by historically attractive equity valuations relative to the bond markets most influenced by QE, but we also are wary of the unintended shocks and consequences from the ending of what is, after all, an unprecedented monetary experiment.
Equity investors will be well served by careful diversification and risk-taking (EXHIBIT) amid a supportive macroeconomic backdrop for corporate profits. First quarter earnings results have given us greater confidence in our analyst forecasts of double-digit earnings growth globally in 2017 and 2018. But we acknowledge that the pace of global economic growth is slowing, and higher valuations worldwide, especially for U.S. and low volatility stocks, present a potential risk to further gains. Opportunities can be found across regions, sectors and investing styles, but they do require a discerning eye.
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