The post-2008 landscape has been characterised by sluggish, yet remarkably steady, economic activity levels and mixed corporate earnings delivery. In this environment, equity market returns have been driven by earnings multiple expansion, as equity investors become willing to pay an ever increasing multiple of future earnings.
What was the cause of this? Within the developed economies central banks have continued down the path of superaccommodative monetary policy, with interest rates maintained near zero – or even negative in some cases – and their respective balance sheets swelled by substantial bond-buying programmes. Taken together, this central bank activity comprises a form of financial repression, sucking yield of interest-bearing securities and making other asset classes, in particular equities, look relatively attractive.
Within the equity market, the preferences of investors have clearly been influenced by this background. Companies able to grow their earnings at an above-average rate– growth stocks – have been sought after, as have firms able to pay an attractive and well-covered dividend – defensive stocks. Less highly-rated equities and those more geared to the economic cycle have tended to lag – at least until the last few months.
This year should see global growth break out of the range to which it has been confined since 2010. We have also had a similarly impressive delivery of corporate earnings. Taken together, these factors support the view that the rally in global equities is now ‘fundamental’ rather than a function of central bank policy. The drivers of this much-improved economic and financial market landscape are several fold: an improvement in the prospects for the emerging economies which have boosted the commodity, manufacturing and global trade cycles; highly accommodative monetary policy in Japan and the Eurozone finally delivering above trend growth and a long overdue pickup in business investment as corporates finally turn their back on their earlier caution in favour of a more optimistic stance.
We are now seeing a positive relationship between strong global growth and corporate revenue growth, with corporate earnings further boosted by a pick-up in margins as corporate pricing power returns. Elsewhere, the rally in global asset markets has generated an ease in so called financial conditions, again, a tailwind for growth. But perhaps the most important point to make is that developed market central banks are, in a careful and measured way, likely to wean the financial markets off the world of easy money over the next 12-18 months. In terms of investor preferences, there has been shift towards favouring sectors which benefit from an improving cyclical outlook, notably technology, financials, industrials and emerging markets.
We have also seen a significant reduction in the correlations between different asset classes and a much wider dispersion of returns within individual equity markets. This suggests to us that central banks may be beginning to have a waning effect on financial markets. This is welcome because it gives investors something which is prized when constructing portfolios– increased diversification.
The pessimists would argue that this environment will presage the next economic and financial market downturn. In particular, they highlight that the economic expansion seen since 2009 is long by historical standards and that a recession is on the horizon. The optimists contend that investment cycles end through economic and financial market overheating and would cite the generally below-target inflation in the developed world and relatively low levels of financial market leverage to argue that we can run somewhat further.
We are cognisant of a number of risks as we head into 2018: policy error on the part of central banks as they signal further withdrawal of policy stimulus, a hard landing in China caused by an unwinding of the credit cycle and host of potential adverse global geopolitical developments. However, we tend to side with the optimists, anticipating the dual tailwinds of good global economic and corporate earnings growth to outweigh concerns over the potential end of easy money. We expect a more challenging year for fixed income, given the current low level of yields and tightness of credit spreads, and we are using an underweight in bonds to fund an overweight in equities. In general we expect earnings to drive regional equity returns and this leads us to overweight Asia, Japan, US and Eurozone, against an underweight in the UK and Latin America.
Jonathan Cunliffe is chief investment officer at Charles Stanley.
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