Where will equities go from here?

Where will equities go from here? Following the recent spike in volatility, many investors will be asking themselves whether this is simply a buying opportunity or the beginning of a paradigm shift in economic policy. In this article, we discuss the shifts occurring in the macroeconomic backdrop that support each these arguments. In spite of the recent correction, equities remain in bull-market territory the question is whether this bull market s supports are beginning to dwindle Asset market volatility Equity markets remain in one of the longest bull markets in recorded history. In recent years, this has been facilitated by a Goldilocks environment of stable, positive economic growth, a low cost of financing and subdued inflation. However, the ongoing strength of the global economy, which has narrowed the output gap, and the combination of easing fiscal policy at this stage in the cycle within the US, has resulted in many market participants questioning how long this environment will persist. Some would argue that the recent sell-off appears to have been initiated by concerns that one of the bull market s key supports, the lack of price pressure within the economy, is beginning to diminish. However, there is reason to believe the move was largely exacerbated by systematic factors associated with short covering by volatility-related investment vehicles (Figures 1 & 2). Indeed, the market s reaction to subsequent strong US inflation data suggests that investors are yet to be convinced that the supportive investment environment is receding. In analysing this situation, we see a number of questions which investors should be asking. Developed world equities and treasury yields 50 160 5 2500 40 120 4 2000 30 20 10 80 40 Yield (%) 3 2 1500 1000 0 0 2010 2012 2014 2016 2018 Equity market volatility Fixed income volatility (RHS) Figure 1: The recent spike in market volatility should be taken in context of the extremely low levels seen throughout 2017. Source: Thomson Reuters Datastream 1 500 2010 2012 2014 2016 2018 10-year treasury yield MSCI World Index (RHS) Figure 2: Treasury yields are approaching the key 3% level, but developed world equity markets remain within a stone s throw of their all-time highs. Source: Thomson Reuters Datastream. MSCI: See Important Information

We expect the corporate earnings backdrop to remain strong, at least in the first half of the year Will robust earnings growth continue? Globally, corporate earnings growth remains very strong, having been further boosted by the recent US tax reforms. Earnings momentum has historically been positively correlated with business activity indices, which are towards the higher ends of their historical ranges (Figure 3). There are a number of reasons to be optimistic about global growth in 2018. President Trump is keen to maintain the US s strong economic performance and the economic benefits of the recent tax reforms are yet to fully materialise. Furthermore, there is scope for a boost from large infrastructure spending plans. Both Europe and Japan are also undergoing economic expansions, each supported by easy monetary policy and with prospects for the implementation of pro-growth fiscal or legislative reforms. Likewise, China s economy is also performing better than expected, although it still faces some longer-term structural headwinds. Overall, we do not believe a global recession is imminent. Business confidence and equity earnings growth 30 65 Earnings growth rate (%) 20 60 10 0-10 -20 40-30 35 02/15 08/15 02/16 08/16 02/17 08/17 US Europe Japan US ISM Manufacturing PMI (RHS) Eurozone PMI (RHS) Japan PMI RHS 55 50 45 Figure 3: Global corporate earnings growth is strong, supported by the positive economic and policy backdrops. Source: Thomson Reuters Datastream Cheap money has been a key support of the current bull market Although there is no precedent as to what will happen as the world s central banks end their asset purchase programmes Is this the end of low borrowing costs? There have been two primary facilitators of the era of low cost financing. First, the world s major central banks have implemented large asset purchase programmes that have ensured abundant liquidity; secondly, demographic shifts have propagated a search for yield among investors. Both of these trends have raised demand for incomeproducing securities, both directly and indirectly, thereby pushing yields lower across many asset classes. For example, low treasury yields have ensured that the discount rate used in equity valuation methodologies has also been kept at a low level relative to the strength of the underlying corporate operating environment, thereby supporting equity valuations. Regarding monetary policy, some of the world s major central banks are gradually withdrawing the unprecedented support they have provided in recent years. The Federal Reserve (Fed) is raising interest rates and has already begun to reduce the size of its balance sheet, thereby withdrawing liquidity. Meanwhile, the European Central Bank (ECB) is tapering its asset purchases, reducing the amount of liquidity it is actively providing to government and corporate bond markets. At the same time, government borrowing is set to accelerate in the developed world. We note that the US government continues to increase its debt limit, with the recent tax reforms expected to add around $1.5tn to its financing bill over the coming decade. Furthermore, President Trump appears to be set on implementing a large infrastructure spending programme, the financing of which is likely to require additional borrowing. As a result, developed-world government bond issuance is set to outpace the rate of central bank asset purchases this year, for the first time since 2015 and at the fastest rate since 2012. These factors are already being reflected in higher US treasury yields (Figure 2).

the process of removing monetary policy support will be managed and gradual but sentiment and expectations could cause its effects to evaporate more quickly The demographic tailwinds supporting the search for yield will also persist for many years Nevertheless, it is important to note that the economic environment will remain accommodative. The major central banks will strive to maintain financial stability and structural headwinds will still act against any acceleration of inflation. This is particularly evident in Japan, where the Bank of Japan (BoJ) has maintained its supportive policy stance as inflation has remained subdued, despite the unemployment rate falling to multi-decade lows. While cheap money has been an important fundamental factor driving asset valuations, it has also had a strong indirect technical effect on equity markets. It has allowed corporates to issue debt at low cost and buy back their own shares. This has reduced the total stock of investable shares and provided a technical boost to equity markets. It has also further improved valuation metrics such as earnings per share. However, if business managers believe that debt is set to become more expensive to finance, they may change strategy in regards to their capital structure plans. There is some evidence that the demographic tailwind that has supported the global search for yield could reverse in the long run. However, this is not expected to occur for a number of years and we believe demand for yield-producing assets will remain strong. How monetary policy encourages share buybacks Monetary policy and demographic trends keeping borrowing costs low Cash-rich corporations able to issue debt at low interest rates Stable growth & Low inflation Equity markets rise Corporations use debt to finance share buybacks The key variable affecting the direction of global monetary policy is inflation Inflationary pressures could also begin to have greater effects on business fundamentals Will inflation accelerate? Inflation is a key input in the decision making processes of the world s major central banks. In the US, the Fed officially introduced its inflation target of 2% in 2012. In the subsequent post-crisis recovery the economy s labour market has tightened and rising inflation is the swing factor coercing the Fed to raise interest rates and reduce the size of its balance sheet. The ECB is also tapering its asset purchase programme as the threat of deflation has receded on the Continent. If wage growth were to pick up, this would weigh on corporate profit margins and, therefore, earnings growth. A key turning point would be if it were to begin to outpace the rate of broader economic growth (in nominal terms), as at this point profit margins would begin to fall in aggregate, in theory. We note that there remains some room before wage growth outpaces economic growth in most major regions (Figure 4).

US GDP and wage growth 6 5 Rate (%) 4 3 2 1 201 0 201 2 201 4 201 6 201 8 Wage growth Nominal GDP growth Figure 4: US economic growth is strong and although wage growth is accelerating, it has some way to go before it will put pressure on corporate profit margins. Source: Thomson Reuters Datastream Overall, inflation is accelerating, but it should remain under control notwithstanding an economic shock such as could be provided by a deterioration in international trade It is debatable whether the investment environment is deteriorating meaningfully It has become time to be more selective Some of the world s major economies business cycles are maturing, in particular the US and Germany, and policymakers are expecting inflationary pressures to continue to build in areas where spare capacity is low. Nevertheless, the internationalisation of labour markets should continue to act as a headwind against inflation, with many economies still exhibiting significant spare capacity. Meanwhile, demographic trends and technological advances, such as increased automation, are providing structural deflationary headwinds. We note that Chinese inflation, a key driver of global inflation, has also fallen in recent months. Together, these factors suggest that inflation will rise gradually, in line with most major central banks forecasts. However, there are a number of potential developments which could alter this expectation. Oil prices have generally been trending higher, boosting non-core measures of inflation, and there is always potential for a geopolitical event to catalyse an oil price shock. A greater threat is presented by the potential for trade disputes, as these can lead to step-hikes in labour or other input costs. In recognition of populist political movements around the world, governments could take a more protectionist stance on trade and immigration. Nowhere is this more evident than the US, where President Trump s America First mantra has already led him to cancel the Trans-Pacific Partnership (TPP). There is a chance that he could also adjust or cancel the North American Free Trade Agreement (NAFTA) between the US, Canada and Mexico. More broadly, there is potential for trade disputes to intensify between the US and its major trade partners, including China. However, this is also a global phenomenon; for example, Brexit already provides a significant risk and we will be watching the upcoming Italian election for signs that its political leaders may seek to distance the country from Europe s core. Conclusion Sovereign bond yields have risen in recent months, albeit from historically low levels, and it could be argued that significant further increases will require a fasterthan-anticipated acceleration in inflation. We note that market pricing and the Fed s projections on the path of US interest rates in 2018 have converged, after the latter had been more hawkish for a number of years. Meanwhile, the benchmark ten-year treasury yield remains below the key 3%-3.5% region and we would only expect investors to begin to shift their equity asset allocations into fixed income on valuation grounds above this. We note that equity earnings yields still remain far higher than US treasury yields. Within equity markets, we believe higher yields will generally favour shorter-duration assets, or value over growth. Likewise, certain sectors, such as financials, will benefit from higher yields; as such, they can provide a hedge against any acceleration in inflation. Within fixed income, the supply-demand dynamics of global corporate bond markets remain more favourable than their sovereign counterparts. This should help contain spreads, even at their current historically low levels, particularly given the

beneficial impacts that the recent tax reforms will have on corporate finances. We would caveat this by acknowledging that a rapid rise in inflation could still catalyse a broader re-pricing of all fixed income assets, including a steepening of the yield curve (the difference between short and longer-term bond yields). and we continue to advocate a balanced approach to portfolio construction Overall, we remain constructive on risk assets. However, recent market events have justified our decision to maintain balance within our clients portfolios, so that they can perform well against a variety of market backdrops. Equity market valuations remain above their historical averages in some areas and the potential for diverging policy and growth backdrops is likely to ensure that sectoral and geographical asset allocation decisions are key determinants of returns in 2018. If inflation rises but remains reasonably contained (our base case), we would expect sectors that can deliver secular above-trend growth, such as technology and healthcare, to outperform. On the other hand, financials should benefit if inflation accelerates. We also believe the alternative asset classes can provide significant diversification benefits, particularly given the specific risks facing sovereign bonds; deep and detailed research remains essential in adequately analysing these sectors, as they can be complex. Stable growth Low inflation Growth slowdown Supportive policy Accelerating inflation Policy normalisation Robust earnings growth Weaker earnings growth

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