November 2017 John Praveen, PhD Managing Director FOLLOW US ON TWITTER: @prustrategist FOR MORE INFORMATION CONTACT: Kristin Meza Phone: 973-367-4104 Email: kristin.meza@ prudential.com Equity Rally likely to Continue Fueled by Strong Q3 Earnings, Solid GDP Growth, U.S. Tax Cuts Likely, BoJ QE, EM Rate Cuts & Gradual Policy Normalization by Fed, ECB & BoE After double-digit gains thus far in 2017, the bull run in global stock markets is likely to extend into year-end, fueled by strong Q3 earnings growth, solid global growth in H2, BoJ & Emerging Markets liquidity support and U.S. tax cuts likely. Further, policy normalization by Fed & ECB likely to be gradual. However, expensive valuations are likely to be a headwind. Stock Market Outlook: Global stock markets continued to add to gains in October on expectations of strong Q3 earnings results, solid global GDP growth, rising prospects of U.S. tax cuts, and no escalation in geopolitical tensions. The Developed Markets gained 2.5% in October, taking YTD gains to 13.5%. The Emerging Markets rose 3.8%, taking YTD gains to 25.9%. Looking ahead, the bull run in global stock markets is likely to extend into year-end fueled by: 1) Strong Earnings Growth with the Q3 earnings season delivering positive earnings surprises. U.S. earnings growth could get a further boost with the passage of tax reforms. Global earnings are on track to post around 13% growth for full year 2017, driven by double-digit growth in the U.S. (11%), Europe (11%), Japan (12%) & Emerging Markets (20%); 2) Solid Global Growth in H2 with the IMF raising its forecast for global growth in its October Outlook, to 3.6% in 2017 and 3.7% in 2018, (from 3.5% & 3.6%, respectively). U.S. GDP grew 3% annualized in Q3, defying expectations of a slowdown from the impact of Hurricanes Harvey & Irma, and on par with 3.1% growth in Q2. Eurozone Q3 GDP grew a solid 2.4% and Japan s economy is expected to grow at an above-trend pace. Growth in the Emerging Markets continues to improve; 3) BoJ & Emerging Markets Liquidity Support with the BoJ likely to continue QQE buying. Emerging Central Banks continue to maintain easy monetary policies. Further, the Fed began shrinking its balance sheet in October. The ECB announced its lower for longer QE strategy, downsizing QE buying starting January 2018, but extended the QE to September. The BoE is likely to raise rates in November with elevated inflation. In addition, stocks are likely to face headwinds from expensive valuations. However, stocks remain attractive relative to bonds with the earnings yield gaps remaining wide with bond yields still low. Further, stock markets continue to face several risks which could derail the rally: 1) Geo-political tensions in Korea continue to simmer; 2) Tensions in Spain with the Catalonia independence referendum; 3) Disappointment on passage of U.S. tax cuts; 4) Renewed Trump troubles if the Mueller inquiry into Russian interference in 2016 U.S. elections leads to some convictions. Bond Market Outlook: Bond yields inched lower in October as inflation reversed, after rising in September. Looking ahead, bond yields are likely to come under upward pressure with: 1) Solid Global Growth in H2 with U.S. GDP growth on track to rebound in Q4 as production, exports and consumption recover after slowing in Q3 due to the Hurricanes. Eurozone Q3 GDP was solid at 2.4%, driven by domestic demand. Japan s growth remains above-trend; 2) Developed Central Banks Normalize Policy: The Fed began shrinking its balance sheet in October. The ECB announced its QE taper to 30bn per month starting January 2018. The BoE is likely to raise rates in November with elevated inflation; However, bonds remain supported in the near term by: 1) Low Inflation as inflation in the U.S., Eurozone and Japan remains low and below target; & 2) Central Bank Support with the BoJ continuing QE buying and rate cuts by some Emerging central banks. Further the ECB announced a lower for longer QE strategy, tapering QE buying starting January 2018 but continue QE buying through late 2018. PGIM is the Global Investment Management Business of Prudential Financial, Inc. Intended for Professional Use Only
Stocks Continue to Rise to Record Highs Fueled by Expectations of Strong Q3 Earnings, Solid Global GDP Growth & Prospect for U.S. Tax Cuts. Fed, ECB & BoE Normalize Policy at Gradual Pace with Low Inflation. BoJ Continues QE Buying & Further EM Rate Cuts Bond Yields likely to face Upward Pressure with Solid GDP Growth, Fed Starts Balance Sheet Normalization & Another Rate Hike in December, ECB Announces QE Taper & BoE Rate Hike. However, Low Inflation is likely to limit Rise in Bond Yields Stock Market Outlook (November): Global stock markets continued to add to gains in October on expectations of strong Q3 earnings results, solid global GDP growth, rising prospects of U.S. tax cuts, and no escalation in geopolitical tensions. The Developed Markets gained 2.5% in October, taking YTD gains to 13.5%. The Emerging Markets rose 3.8%, taking YTD gains to 25.9%. After double-digit gains thus far in 2017, the bull run in global stock markets is likely to extend into year-end as the Q3 earnings season continues to deliver positive surprises, global growth remains solid, and progress on U.S. tax cuts. Further, BoJ QE buying and rate cuts in some Emerging Markets are likely to provide liquidity. In addition, the Fed s balance sheet normalization is likely to proceed at a gradual pace and the ECB announced a lower for longer QE strategy, tapering QE buying, but extending the buying into late 2018. 1) Stocks Supported by Expectations of Strong Q3 Earnings Growth: Stocks remain supported by expectations of solid earnings growth in Q3 with the earnings season having just begun. Global earnings are on track to post around 13% growth for full year 2017, driven by double-digit growth in the U.S. (11%), Europe (11%), Japan (12%) & Emerging Markets (20%). The U.S. Q3 earnings season began in October and expectations are for earnings to post a solid YoY gains for the quarter after finishing Q2 on a strong note, with earnings growth of 12.4%. Expectations for 2017 earnings growth remains solid, around 11%, while expectations for 2018 have been upgraded to around 11.5% from 11% earlier. U.S. earnings outlook could get a further boost with the passage of tax reforms, which could include lower rates as well as a favorable repatriation tax on profits held overseas. A lower corporate tax rate could result in additional 10% boost to earnings with the prime beneficiaries being Energy and Financials. Eurozone earnings are on track for another solid quarter in Q3 after posting strong growth of 16% in Q2 and 15.3% in Q1. Eight of the ten sectors in the index are expected to post positive YoY growth for the quarter. Eurozone earnings growth is expected around 11% in 2017 driven by the ongoing synchronized upswing in global growth but offset somewhat by euro appreciation year to date. Japanese earnings growth expectations for 2017 have been revised lower to around 12% with the yen remaining volatile in past few months. The yen rose modestly in Q3, averaging 110.96/$ for the quarter after 111.11/$ in Q2 and 113.61/$ in Q1. However, the yen remains weaker than corporate expectations of an average rate of 108/$ over FY2017-18 which should support earnings. Japanese earnings also remain supported by the improvement in global demand while domestic demand is also improving with GDP growth expected to remain solid, around 1.5-2% in coming quarters. Emerging Markets earnings outlook remains strong with improving GDP growth and steady commodity prices expected to drive earnings growth to around 20% for 2017. EM Asia earnings growth have been revised modestly higher to around 22% for 2017 after 3% growth in 2016. LatAm earnings growth is expected to remain strong at 22% in 2017 after 54% in 2016, while EMEA earnings are expected to grow 9% in 2017 after 6% in 2016. 2) Solid Global Growth in H2 after Improved H1 GDP Growth: Stock markets remain supported by solid global GDP growth in H2. The IMF, in its October Outlook, raised its outlook for global growth in 2017 and 2018, expecting 3.6% growth in 2017 and 3.7% in 2018 (from 3.5% & 3.6%, respectively, in the July forecast). The upward revision reflects a broad-based acceleration of growth in Eurozone, Japan, EM Asia, EM Europe, and Russia. Emerging Market growth is expected to strengthen to 4.6% in 2017 and 4.9% in 2018-2019 from 4.3% in 2016. The U.S. economy surprised on the upside with Q3 GDP growth of 3% annualized defying expectations of slowdown from impact of Hurricanes Harvey & Irma, above consensus expectations of slowing to 2.5% from 3.1% in Q2. The Q3 growth was driven by stronger trade, reflecting robust global growth, solid inventory build-up and healthy 2
consumer spending. The key contributions to Q3 GDP growth came from consumption (+1.6%), inventories (+0.7%), business investment spending (+0.5%) & trade (+0.4%). Japan s economy is expected to grow at an above-trend pace, with Q3 GDP growth around 1.5%, driven by solid consumer and business investment spending. Eurozone GDP grew 2.4% QoQ annualized in Q3, better than the expected 2% growth rate. In addition, Q2 GDP was revised up to 2.8% from 2.4%. Full details are not yet available. By country, French GDP rose 2% QoQ annualized a slowdown from 2.4% in Q2, while Spanish GDP continues to grow at a solid pace, up 3.2% QoQ annualized in Q3 after a stronger 3.6% in Q2. U.K. GDP rose 1.6% QoQ annualized in Q3, slightly better-than-expected (1.2%), after 1.2% in Q2. U.K. GDP rose 1.6% annualized in Q3, improving from the 1.2% pace in Q2. Growth is expected to remain weak in Q4, with domestic demand struggling due to Brexit uncertainty. Among Emerging Economies, China s GDP grew 6.8% YoY in Q3 after 6.9% in Q2. Services sector growth rose 8% YoY in Q3 after 7.6% in Q2 on the back of healthy domestic consumption and healthy external demand. However, industrial and construction activity slowed, likely due to the anti-pollution campaign. The IMF raised China s growth outlook to 6.8% YoY in 2017 (from 6.7%), and to 6.5% in 2018 (from 6.4%) India s GDP growth is expected to improve to 6-6.5% range in H2 2017 as the impact of currency demonetization fades, and the economy recovers gradually from the initial impact of the GST. The Brazilian economy remains on a recovery path with Q3 GDP growth expected to remain modest, around 0.4% annualized, but on track to strengthen in Q4 and further in 2018, to above a 3% pace, as consumption strengthens, investment spending recovers, and government spending stabilizes after earlier declines. GDP growth remains solid in Mexico (2.4%), Turkey (5.1%), Russia (2.5%), Korea (2.7%) and Taiwan (2.1%). 3) Reduced Liquidity Tailwinds with Gradual Policy Normalization by Developed Central Banks, but BoJ & Emerging Markets Continue to Ease: Stock markets are likely to face reduced liquidity tailwinds as developed central banks are in the process of gradually normalizing policies. The U.S. Fed began its balance sheet normalization in October, following the procedures outlined in the June meeting addendum. The Fed s projections still imply a gradual process of tightening policy, with another 25bps hike in 2017 and 50 to 75bps of rate hikes in 2018. Market focus is now on who President Trump will nominate as next Chair of the Federal Reserve. The Bank of Japan is likely to remain on hold at its late October meeting. While the BoJ is unlikely to change its policy framework anytime soon, market focus is now on the choice for the next BoJ Governor after PM Abe and the LDP won a landslide victory in the October 22nd snap elections. The ECB announced its lower for longer QE strategy, at its late October meeting, as expected. The ECB will trim its asset purchases to 30bn per month beginning in January 2018, from current 60bn per month, but will extend the QE purchases through September 2018. The ECB will continue reinvesting principal payments for an extended period. They also left themselves the option to increase the size or duration of these purchases if needed. The BoE meets next in early November and is likely to raise rates with U.K. inflation continuing to rise. Whether the November rate hike is just a reversal of the August 2016 insurance rate cut, or start of a tightening cycle is likely to depend on the trajectory of U.K. GDP growth and inflation, and the state of Brexit negotiations (which remain difficult). Emerging Central Banks continue to maintain easy monetary policies with rate cuts in some markets (Brazil & Russia) and rates on hold in others (India, China, Mexico, Turkey, Taiwan, Korea and Eastern Europe). Brazil s central bank slowed its pace of rate cuts in October, reducing rates by 75bps to 7.5% after cutting rates by 100bps in April, May, July, and September. The Central Bank of Russia (CBR) cut rates by 25bps to 8.25% at its October meeting with headline inflation falling to 3% YoY in September and is now expected to undershoot the CBR s 3.5-3.8% forecast for 2017. Mexico s central bank, Banxico, left the overnight rate unchanged at 7% in September. The bank is likely to remain on hold as it feels that inflation has likely peaked and will begin to moderate. Further, the recent Mexican earthquakes raise risks to GDP growth. The Central Bank of Turkey (CBT) kept rates on hold at its October meeting as inflation remains elevated reaching 11.2% YoY in September. The People s Bank of China (PBoC) announced a targeted Reserve Requirement Ratio (RRR) on September 30th to encourage lending to micro-and-small enterprises (MSE), agricultural sector, start-ups, consumption and education of the poor, effective Q1 2018. With the 19th National Congress of the Communist Party of China ending on October 24th, the PBoC is likely to announce new measures in line with the policy priorities announced at the party Congress. The central bank of Taiwan is expected to 3
keep rates on hold at its December meeting. The Reserve Bank of India kept rates unchanged in October and is likely to remain on hold in the coming months with the uptrend in inflation. Indonesia cut rates in September but was on hold in October. Korea, Hungary, Romania, and Poland remain on hold with improving growth. The Czech Republic left policy on hold in September after the August hike. 4) Equity Valuations Remain Modestly Expensive & likely to be Headwinds for Market Gains: Equity valuations continued to rise in September with P/E multiples trending higher as stocks posted further gains on solid earnings results, Angela Merkel winning German elections, and unexpected progress on U.S. tax cuts more than offset the strongerthan-expected Q2 earnings results. The Developed Markets (MSCI World Index) P/E multiple increased to 20.9X in September from 20.8X in August, and remained above the long-term average multiple of 20.5X (20-year average). The trailing P/E multiple for the S&P 500 rose in mid-october to 21.8X from 21.6X at the end of September and 21.1X in August. The P/E multiple for Japanese stocks (TOPIX) rose to 16.1X in October from 15.6X in September and 15.1X in August. In Eurozone, the STOXX P/E rose slightly to 21.6X in mid-october after rising to 21.5X in September from 20.8X in August. Emerging Market (EM) P/E multiple eased to 15.3X in September from 15.6X in August, but remain modestly above their long term (20-year) average of 15X. However, EM valuations remain attractive relative to DM stocks. Stocks remain cheap relative to bonds on an Earnings Yield Gap basis even though the gap is shrinking in October with bond yields almost unchanged from last month while the earning yields continued to decline. Bottom-line: Global stock markets continued to add to gains in October from September. The Developed Markets gained 2.5% in October, taking YTD gains to 13.5%. The Emerging Markets rose 3.8%, taking YTD gains to 25.9%. Looking ahead, equity markets are likely to remain in an uptrend, driven by: 1) Strong Earnings Growth with the Q3 earnings season delivering positive earnings surprises after strong earnings growth in H1. U.S. earnings growth could get a further boost with the passage of tax reforms, which could include lower corporate tax rates and a favorable repatriation tax on profits held overseas. Given the strong H1 earnings growth, global earnings are on track to post around 13% growth for full year 2017, driven by double-digit growth in the U.S. (11%), Europe (11%), Japan (12%) & Emerging Markets (20%); 2) Solid Global Growth in H2 with the IMF raising its forecast for global growth to 3.6% in 2017 and 3.7% in 2018 (from 3.5% & 3.6%, respectively). Emerging Markets growth is expected to strengthen to 4.6% in 2017 and 4.9% in 2018-2019 from 4.3% in 2016. U.S. GDP grew 3% annualized in Q3, defying expectations of slowdown from impact of hurricanes Harvey & Irma, above consensus expectations of slowing to 2.5% from 3.1% in Q2. Eurozone continues to grow at a solid pace with Q3 GDP growing 2.4% annualized. Japan s economy is expected to grow at an above-trend pace, driven by solid consumer and business investment spending. U.K. GDP rose 1.6% annualized in Q3, improving from the 1.2% pace in Q2. Growth in the Emerging Markets continues to improve led by solid growth in China, Mexico, Turkey, Korea, Taiwan and India expected to rebound after the Q2 slowdown. Brazil and Russia remain on recovery track; 3) BoJ & Emg Markets Liquidity Support with the BoJ likely to continue QQE buying with inflation well short of the Bank s target. Emerging Central Banks continue to maintain easy monetary policies with rate cuts in some markets (Brazil, & Russia) and rates on hold in others (India, Indonesia, China, Mexico, Turkey, Taiwan, Korea and EM Europe). Further, the developed central banks policy normalization is likely to be gradual with inflation still below target in the U.S. & Eurozone. The Fed began shrinking its balance sheet in October. The ECB announced its QE strategy of lower for longer, downsizing QE buying starting January 2018, but continuing QE buying through late 2018. The BoE is likely to raise rates in early November with elevated inflation. In addition to reduced liquidity tailwinds from developed central banks, stocks are likely to face headwinds from expensive valuations. P/E multiples in most markets remain elevated and above longterm averages as strong earnings growth is being offset by price gains. However, stocks remain attractive relative to bonds with the earnings yield gaps remaining wide with bond yields still low. Further, stock markets continue to face several risks which could derail the equity rally: 1) Geo-political tensions in Korea continue to simmer. While diplomatic efforts are under way to resolve the tensions in the Korean peninsula, the acrimonious rhetoric from the North Korean dictator and U.S. President Trump is likely to hinder the diplomatic efforts and rattle markets; 2) Catalan tensions in Spain: The Catalonia independence referendum and potential break-away and the Spanish government s strong reaction raises fresh questions about EU integration; 3) Disappointment on passage of 4
U.S. tax cuts if the Republicans fail to vote in unison; 4) Renewed Trump Troubles if the Mueller inquiry into Russian interference in 2016 U.S. elections and the alleged links between Russia and Trump operatives leads to convictions.. Bond Yields likely to face Upward Pressure with Solid GDP Growth, Fed Balance Sheet Normalization, ECB QE Taper & BoE Rate Hike. Bonds Supported by Low Inflation Bond yields are mixed in October after rising in September. In October, U.S. 10-yr Treasury yields rose 10bps to 2.42%, Eurozone yields edged down 1bp to 0.43%, U.K. yields declined -1bps to 1.35%, while JGB yields edged up 1bp to 0.07%. Looking ahead, bond yields are likely to remain under upward pressure with solid global GDP growth momentum, policy normalization by developed central banks and easing geopolitical tensions. However, low inflation is likely to limit the rise in bond yields. Bond yields are likely to come under upward pressure with: 1) Solid Global Growth in H2 with the IMF raising its forecast for global growth. U.S. GDP grew 3% annualized in Q3, defying expectations of slowdown from impact of hurricanes Harvey & Irma, above consensus expectations of slowing to 2.5% from 3.1% in Q2. The Eurozone continues to grow at a solid pace, with Q3 GDP growing 2.4% annualized. Japan s economy is expected to grow at an above-trend pace, driven by solid consumer and business investment spending. U.K. GDP rose 1.6% annualized in Q3, improving from the 1.2% pace in Q2; 2) Developed Central Banks Normalize Policy: The Fed began shrinking its balance sheet in October. The ECB announced its QE taper to 30bn per month starting January 2018. The BoE is likely to raise rates in November with elevated inflation; However, bonds remain supported in the near term by: 1) Low Inflation as the recent uptick in inflation has reversed and inflation in the U.S., Eurozone and Japan remains low and below target; & 2) Central Bank Support with the BoJ continuing QE buying and rate cuts by some Emerging central banks. The ECB announced its QE strategy of lower for longer, tapering QE buying starting January 2018 but continuing QE buying through September 2018 and beyond. Investment Strategy: Asset Allocation: Equity Rally Continues with Strong Q3 Earnings, Solid GDP Growth & U.S. Tax Cuts Likely Stocks: Remain Overweight as the equity bull run is likely to extend into year-end as the Q3 earnings season continues to deliver positive surprises, global growth remains solid, and renewed prospects of U.S. tax cuts. Further, liquidity support with BoJ QE buying and rate cuts in Emerging Markets. Bonds: Remain Underweight as bond yields are likely to face upward pressure with solid global GDP growth momentum, Fed starts balance sheet normalization & another rate hike in December, ECB to announces QE Taper & BoE hikes rates. However, easing inflation likely to support bonds. Global Equity Strategy: Modest Overweight in Emerging Markets & U.S., Raise Japan to Modest Overweight, Neutral in Eurozone & Underwt in U.K. Emerging Markets: Remain Modest Overweight with EM central banks maintaining easy monetary policies, improved GDP growth with the IMF raising its growth forecast for EM growth, and strong earnings outlook. However, policy normalization by Fed, ECB & BoE remains a risk. U.S.: Remain Modest Overweight with increased likelihood of U.S. tax cuts, Q3 earnings delivering positive surprises after strong Q2 earnings, and GDP growth solid in Q3 despite hurricane impact and on track to remain solid in Q4. Fed balance sheet roll-off and another rate hike in December are likely to be negatives. Japan: Raise to Modest Overweight with a landslide win for PM Abe and the LDP in the October elections, paving the way for a fresh boost for reforms and Abenomics, and for continuation of BoJ s ultra-easy monetary policies. This should keep the yen weak and boost earnings and exports. Eurozone: Lower to Neutral with solid GDP growth and earnings outlook offset by potential for increased volatility with Catalan tensions in Spain. The ECB announced its lower for longer QE taper strategy. The Catalonia independence movement in Spain is another risk. 5
U.K.: Remain Underweight as Brexit negotiations remain deadlocked and uncertainty remains elevated. GDP growth remains weak with domestic demand struggling. Despite weak growth, the BoE is on track to raise rates at the next meetings with inflation elevated at 3%, well above the 2% target. Global Bond Market Strategy: Bonds Yields to come under Upward Pressure with Stronger GDP Growth & Central Bank Policy Normalization. EM Debt: Remain Modest Overweight with EM central banks maintaining easy monetary policies, improved GDP growth with the IMF raising its growth forecast for EM growth. However, policy normalization by the Fed, ECB & BoE, geopolitical tensions & continued Brexit uncertainty remain risks. Japan JGBs: Raise to Modest Overweight as the outlook for Japanese JGBs remains favorable with low inflation, modest growth, and the landslide win for PM Abe in the October election. The big Abe win paves the way for continuation of BoJ s ultra-easy monetary policies which should support JGBs. Eurozone: Remain Neutral with inflation remaining low, but offset by solid GDP growth and the ECB announcing its QE taper strategy of lower for longer. Eurozone Q3 GDP was solid at 2.4%, driven by domestic demand. Catalan tensions in Spain are a risk. U.K. Gilts: Remain Underweight with the BoE is likely to hike rates in November with inflation elevated at 3%. However, GDP growth remain weak due to Brexit uncertainty, which could limit the rise in yields. U.S. Treasuries: Remain Underweight as Treasury yields are likely to rise with Q4 GDP rebound and policy normalization by the Fed, but inflation remains low. U.S. GDP growth solid in Q3 despite hurricane impact and on track to remain solid in Q4. The Fed began balance sheet roll-off in October and likely to raise rate again. Global Sector Strategy: Overweight: Industrials, Information Technology; Modest Overweight: Healthcare & Financials; Neutral: Energy, Materials, Consumer Discretionary & Telecomms; Underweight: Consumer Staples, Real Estate & Utilities. Disclosures: PGIM Global Partners is a brand name of Prudential International Investments Advisers, LLC. (PIIA), a Prudential Financial, Inc. (PFI) company. PIIA is an investment adviser registered with the Securities and Exchange Commission of the United States. PFI, a company incorporated and with its principal place of business in the United States of America is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom. 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