As the market continues to digest President Trump’s every tweet for policy nuances, we should not be distracted from the fundamental backdrop. The European economy is recovering, with the eurozone’s economic surprise peaking last month at levels not seen since early 2013. This has already been reflected somewhat in the bond yield inspired rotation that we have seen towards more ‘value-oriented’ and cyclical sectors. For this to be sustained, we believe that bond yields need to continue drifting higher and earnings must deliver.
We are accustomed to a hawkish Federal Reserve being negative for the US equity market. Not so now it would seem. The Federal Reserve has announced that it sees neutral real rates in the US around 1% higher. However, judging by market movements in recent weeks, investors do not appear to be fully embracing this view. Each day a new record-high seems to be printed – perhaps over-exuberance given the uncertainty that still exists regarding Trump’s policies. As we await clarity on the Trump administration’s policies, there remains the potential for highly disparate returns over 2017 as the winners and losers begin to emerge.
The fall in US bond yields since their December high challenges the post-Trump ‘reflation trade’. However, we continue to believe that evidence of a synchronised, cyclical acceleration and rising global inflationary pressures will give this trade further track to run. Financials should benefit at the expense of ‘quality’ stocks, which are still relatively expensive compared to history. Domestic stocks pose a dilemma for 2017. We feel that some estimates (post last year’s Brexit vote) have become too bearish. However, continued uncertainty surrounding the form of Brexit and its eventual impact on the domestic economy are likely to weigh on valuations throughout the remainder of this year.
Emerging market equities
A reasonably broad array of short-term and long-term economic indicators continue to paint a robust picture for growth and global inflationary pressures. For example, China’s latest PPI data was the strongest in around six years, suggesting that reflationary pressures continue. Combined with persistent improvements in earnings expectations, we see the potential for positive returns in emerging markets. Valuations have, indeed, moved above historical averages, but they still remain supportive in an upturn phase. Potential headwinds are likely to be the threat of Trump-induced trade wars and the impact of a strong US dollar.
The economic background continues to be more positive and less bond-friendly despite the many uncertainties that the global economy faces. In the US, Europe and the UK, economic growth continues to tick along and inflation keeps rising, albeit slightly exaggerated by base effects such as oil prices. Central banks have, however, yet to move. In the US, Federal Reserve Chairman, Janet Yellen, has been sounding increasingly hawkish, but no action is expected until the Trump fiscal boost is quantified. In Europe, the ECB remains at an easing stance. Despite aggregate figures for the eurozone bloc showing inflationary pressures picking up, some countries (e.g. Italy) are still seeing deflation. Until this situation changes, we see talk of tapering as premature.
We view the current credit cycle as relatively mature, particularly for non-financial issuers. There has been a slow, but steady, migration down in credit quality within the investment grade markets in recent years as corporates look to favour shareholders with higher capital returns or engage in mergers and acquisitions. With the cost of debt likely to remain close to historic lows for the short to medium term, it is difficult to see a catalyst at present that will cause this trend to reverse. Current valuations provide little in the way of risk premia, particularly given the recent upward trajectory in government bond yields. As such, we do not view now as an attractive entry point for investing in the broad investment grade market and prefer to look elsewhere for better opportunities in credit.