Global Economic Update (2016/OCT)

The readjustment of valuations is likely to remain a key theme in coming months

Morningstar Analysts 26 October, 2016 | 11:16
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Outlook for Investment Markets

Bond, equity and property markets have struggled in recent months with the prospect of higher interest rates in the United States—valuations across many asset classes had been inflated to expensive levels by very low interest rates. The readjustment of valuations is likely to remain a key theme in coming months, though the headwinds are moderated to some degree by ongoing growth in the global economy and by the likelihood that bond yield rises will be modest and gradual.

International Fixed Interest — Outlook

Fixed interest markets remain heavily focused on the outlook for U.S. monetary policy. Unusually among the major economies, the U.S. has been able to raise inflation roughly to where its central bank would like it to be with the “core” consumer price index in the U.S., which excludes food and energy, showing an annual inflation rate of 2.3% in August and 2.2% in September.

One of the conditions for the Fed to start normalizing monetary policy consequently looks in place: inflation is back to acceptable levels. The only thing holding the Fed back is the state of the “real” economy, and in particular, the state of the labour market, as it is yet not definitive the economy is in robust enough health to deal with what might well be a succession of monetary policy tightenings.

Unfortunately, there has been nothing in the recent economic statistics that has clearly settled the matter one way or the other, and investors have been left to pore over the public statements of Fed decision-making members for clues as to when the first increase might occur. The current consensus both in the financial futures markets and among economic forecasters is that the Fed is likely to lift its target range for the Fed funds rate from its current 0.25%–0.50% to 0.50%–0.75% at its meeting on Dec. 14.

There are also hints global inflation may be about to start to rise from its unusually low levels. Large increases in Chinese manufacturing production, for example, have been holding down world prices, until recently, where Chinese output prices have been falling. In September, however, the Chinese producer price index (which measures factory gate prices) showed that prices had stopped falling, and were now marginally (0.1%) above year-ago levels.

There have been false dawns before with investors misled into thinking that ultra-low bond yields were finally starting to move back to more normal levels, only to find yields reversing course and heading back to where they started (or even heading lower again). This time around, however, there is a real likelihood that U.S. bond yields are set to move higher in response to higher U.S. inflation and less supportive monetary policy, and U.K. yields may also rise further as the Brexit process unfolds.

While global bonds still have insurance value in what remains an uncertain world economy, the asset class will face risks of capital loss as yields normalise. The risks are likely to be highest in areas where investors have been most aggressive in chasing down pockets of higher yield, which would include emerging market debt and “junk” low-quality corporate bonds.

International Equities — Outlook

Global equity investors’ attention has been heavily concentrated on the U.S. market, as it has been the cornerstone for overall global equity performance. As noted earlier in the “International Fixed Interest” section, however, it has not been easy to get a clear read on America’s prospects. Recent data on the U.S. economy has not been consistently strong or weak, leaving the Fed (as well as equity investors) somewhat in the air about the American economy’s ability to absorb less supportive monetary policy.

September retail sales, for example, were strong (up 0.6% for the month, meeting forecasters’ expectations), but on the other hand, consumer confidence (on the University of Michigan measure) unexpectedly dropped in October. It could be that the survey is picking up households’ anxieties over the forthcoming U.S. presidential election—respondents were happy about current economic conditions, with the fall in confidence wholly down to reduced optimism about the future outlook—and may reverse for the better after the Nov. 8 vote, but only time will tell.

There has also been mixed news elsewhere. The August results from the Institute of Supply Management’s Manufacturing and Non-Manufacturing PMIs had been weak, but September’s results have been clearly better with, in particular, strong readings for new orders and a clear pickup in planned employment. The most likely outlook is for ongoing but subdued growth, with the latest (October) Wall Street Journal poll of U.S. forecasters on average picking GDP growth at a 2.0% to 2.5% rate over the next year—not spectacular, but not shabby, and suggestive of modest prospects for corporate profit growth.

Recent profit performance has not been stellar, mostly due to the plunge in profits in the energy sector when the oil price fell, but appears to be recovering. While it is early days for the September quarter reporting season (only about 10% of the S&P 500 companies had reported at the time of writing), a higher proportion than usual were beating analysts’ expectations, and the outlook is for further improvement. Data company FactSet’s compilation of the latest analysts’ profit forecasts shows a better year ahead. A predicted rebound in energy sector profits complicates the aggregate numbers (the overall expected profit growth for the S&P 500 is a distortedly large 12.8%) but ex-energy most sectors (other than real estate) look set for reasonable profit growth in 2017.

The key investing issue is valuation. On FactSet’s estimates, the prospective P/E ratio is 16.4 times expected earnings. However, this is higher than normal—the long-run average is 14.3 times—and is vulnerable to both higher bond yields and adverse economic, financial or political shocks.

In the circumstances, it is not surprising that global fund managers have been taking an increasingly cautious approach. The latest (October) survey by Bank of America Merrill Lynch found, for example, that fund managers have been dialling up cash holdings to unusually high levels, and that they are underweight to most of the major equity markets, particularly to the U.K. but also to the U.S. and Japan. Only Europe attracted a modest overweight, presumably on cheaper valuations rather than on superior economic prospects. The Economist magazine’s latest (October) poll of international forecasters has the eurozone growing by only 1.3% next year.

Fund managers, partly out of necessity (because other options are not looking so attractive) and partly opportunistically (because valuations are better and some developing economies have strong growth prospects), have moved heavily into emerging markets, where a large net balance of managers are now overweight. As an option in current conditions it makes sense, but it too is not riskless: while some of the leading emerging economies are improving (notably Brazil, Mexico and Russia), others (including South Africa, Thailand and Turkey) have recently been throwing up problematic levels of political risk.

The outlook remains one where the outlook for global economic activity and global corporate profitability are modestly positive, but equity valuations are expensive for what is on offer, and vulnerable to any further rises in interest rates that would upset the relative valuations of bonds and equities. There are also unusually high levels of risk: the fund managers’ survey showed that, in addition to pressures from the bond markets, investors are especially worried about further EU disintegration now that the U.K. has opted for Brexit, and about Donald Trump potentially winning the U.S. presidential election. World equity markets face some further headwinds in coming months.

 

Performance periods unless otherwise stated generally refer to periods ended 17 October 2016.

 

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