Written by: Paul Quinsee, Global Head of Equities, J.P. Morgan Asset Management
For more than a year now, a stronger, broader global growth environment has driven an acceleration in corporate profits around the world. As we approach the end of 2017, our estimates for a continued synchronized earnings recovery sustain what we would describe as our tempered optimism. We think this recovery will continue for a good while yet and are not expecting a recession (even for the now late-cycle U.S. economy) over the next couple of years. Our analysts’ forecasts of double-digit earnings for 2017 and 2018 look to be very much on course, having been supported by a wide range of positive second-quarter corporate results. As bottom-up stock pickers, we are finding ample opportunities, especially in Europe, Japan and emerging markets.
But our optimism is restrained. Higher equity valuations—and the absence of a significant market correction for quite some time—make us more cautious now. Our investors now expect average, not outsize, gains over the next 18 to 24 months. The eventual unwinding of global central bank balance sheet expansion, slated to begin with the Federal Reserve (Fed) in October, will surely present challenges. And after a strong run for global equity markets, we must guard against the trap of investor complacency and excessive risk taking.
In the following pages of our quarterly Global Equity Views, we present our investment outlook, discuss market trends and spotlight opportunities and potential risks.
Economic growth and corporate earnings
The breadth of global growth has encouraged once-skeptical investors who worried that the growth was too U.S.-centric. We now see synchronized growth and rising growth expectations across both developed and emerging markets. Purchasing Managers’ Index (PMI) readings show continued healthy levels, and in emerging markets the pace of GDP growth and the breadth of industrial production growth are increasing. Some have taken to comparing this to the old cliché of a “Goldilocks” environment. It can’t last forever, of course, but we think the not too hot, not too cold environment should prevail through 2018.
Earnings are driving markets higher (EXHIBIT 1), and we are forecasting double-digit EPS growth globally in 2017 and 2018. In the U.S., a combination of steady revenue growth, improved margins and heavy share buybacks has boosted earnings growth for several years, and we expect this to continue. However, higher debt levels will eventually constrain buybacks. In Europe, corporate profits are growing for the first time in six years, although we do acknowledge further euro strength as a potential headwind. Strong operating leverage for Japanese corporations should help propel earnings gains this year and next. In emerging markets, we project high double-digit profit growth in 2017.
So far this year, equity markets have been led by growth stocks, especially a small group of Internet companies with the market monikers BAT (Baidu, Alibaba and Tencent) and FANG (Facebook, Amazon, Netflix and Google). Some investors see a bubble forming here, drawing parallels with the extreme prices of many technology stocks in 1999. But on balance we are less concerned, given that these companies boast massive user bases, impressive growth rates and in many cases strong profitability as well. The recent rally has made them less attractive, but their valuations do not seem unreasonably high just yet. Potential regulation is the biggest risk.
Earnings growth has driven this year’s rally
EXHIBIT 1: COMPOSITION OF TOTAL RETURNS THROUGH SEPTEMBER 30, 2017
From a regional perspective, we still see more upside potential in emerging markets and developed markets ex-U.S. In emerging markets, earnings are growing and valuations are still reasonable—we have only seen half the multiple expansion that we see in a typical emerging market up cycle. In international markets, our investors continue to acknowledge new themes; for example, activism in Europe is a new reality, and the number of European companies subject to activist campaigns has tripled over the past five years (while the number of U.S.-targeted companies has dropped). It is evident that there is plenty of opportunity for European companies to improve profitability and allocate capital in more shareholder-friendly ways. Greater capital discipline is also evident in Japan, where stocks look more reasonably priced than we have seen for many years.
From a style perspective, growth has outperformed value this year. Our investors see more opportunity in value stocks, but a major style rotation from growth to value seems unlikely in the near term. Within value and across global markets, many financials still look promising. Not only do they stand to benefit from higher interest rates, but their valuations are still relatively attractive, and many management teams are beginning to return more capital to shareholders. Some of our value investors are also finding opportunities in deeply out-of-favor retailers, believing that the fear of Amazon is perhaps overdone in some cases. And across investment styles, we are finding opportunities in relatively wide spreads between sectors (for example, “bond proxies” vs. cyclicals) vs. relatively narrow spreads within sectors.
Surprises are always interesting, and the surprising extent of capacity reductions in many basic industrial businesses is intriguing to our investors. A large number of the capacity cuts have occurred in China, where the government has incentivized politicians to close down capacity in their region (often for environmental reasons), a trend that began with coal and continued with steel and aluminum. Capital deployment trends are also positive for many industrial companies, although the U.S. energy sector remains an exception.
Reduced monetary stimulus
The slowdown in the expansion of central bank balance sheets—which ballooned from $4 trillion pre-financial crisis to $17 trillion today—presents a clear challenge to investors. The slowdown, already underway, is set to enter a new phase with the Fed’s first post-QE reduction in its balance sheet.
How might the unwinding of quantitative easing impact capital markets? It is the subject of intense debate. Some forecasters expect a very gradual rise in interest rates, while others fear a more abrupt dislocation as the tide of liquidity begins to retreat. We take some comfort from the still relatively attractive valuations of stocks vs. bonds.
Over the near term, our investors worry about complacency, especially after such a strong run in equity markets. In this context, some point to the CBOE Volatility Index (VIX) nearing 30-year lows. However, we note that many of the usual warning signs of a looming market downturn are not yet visible. Retail investors still seem cautious, and IPO activity continues to be moderate. Most important, valuations
It’s been a great year for equity markets around the world. We see enough opportunity to keep investors engaged, but our optimism is tempered by higher valuations and the potential for increased risk appetite to eventually lead to excessive risk-taking. We advise investors to stay diversified and look for opportunities in value stocks and international markets. However, some higher equity valuations, especially in the U.S. and in some bond equivalent sectors, do warrant close attention, with an eye toward the possibility of a short-term correction. Equity investors should be prepared for a market pullback but not yet positioned for the more substantial downside that usually comes with recessions.
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