The game is far from over
While global equity markets have been grappling with the risk of higher interest rates, inflation and geo-political events in recent months, this is not the start of the long-feared bear market.
After having started the year with almost nothing to fear but the lack of fear itself, global equity markets have retreated in recent months and are still struggling to regain past peak levels.
Investors are grappling with several countervailing forces – ongoing solid corporate earnings growth, the risk of higher interest rates and inflation, and various geo-political brushfires started by none other than the President of the US.
My base case view is that this is not the start of the long-feared global equity bear market. After such a long global economic expansion since the financial crisis, and one of the longest bull markets in history, it’s perhaps reasonable to fear that the good times must eventually come to an end.
Make no mistake – they will. Tightening labour markets and rising oil prices are tentative signs that the global economy is moving beyond its goldilocks period of low inflation and spare capacity. The next year or so could be a lot more challenging.
But if this were a game of good old American baseball, I’d argue we’re probably still in the 6th or 7th innings, rather than the 8th or 9th. Using a sport more familiar to Australians, I reckon we’re heading into the 40th over rather than the last ball of a 50 over one-day game.
Whatever game you choose, the message is the same: the game is still on and there are more runs to be made.
To understand why, it’s worth considering the risks and opportunities still facing the market.
For starters, the one clear positive remains continued generally good economic growth indicators across much of the world. Although it softened a little earlier this year, the JP Morgan-Markit Global Composite Index edged higher in April, and still remains at fairly healthy levels. While European and Japanese growth have slowed somewhat so far in 2018, this is coming off the back of what seemed unsustainably strong growth in late 2017. Meanwhile, US economic growth has remained firm, with consumer spending especially picking up in recent months after a slow start to the year.
Helped by recent US tax cuts, US earnings growth has remained firm.
According to US research firm FactSet, around 78 per cent of US S&P 500 Index companies produced March quarter earnings results that beat market expectations – which are well up on the average ‘beat’ ratio of 70 per cent over the past five years.
What’s more, while US tax cuts have been an important recent driver of improved earnings performance, other factors such as the economy’s strength, rising oil prices and a weaker US dollar, have also played key roles. Indeed, revenue performance has been even more impressive – with 77 per cent of companies beating revenue estimates, compared to a 5-year beat ratio of only 57 per cent.
As for the global tech giants, despite recent controversies over the use of private data at Google and Facebook, both their users and advertisers have so far remained loyal. Apple’s performance has been so good that famed US investor, Warren Buffett, has upped his stake in the company several times over the past few months.
Current earnings expectations, which may well be revised up a little further in coming months, suggest US forward earnings could rise another 10 per cent or so by year-end. Growth in global earnings more broadly should not be far behind.
Are valuations a concern? Although many analysts point to above-average price-to-earnings ratios, my own analysis suggest valuations are reasonable given the still relatively low level of bond yields. Indeed, even with US 10-year bond yields around 3 per cent, fair-value for the S&P 500 Index would be a price-to-forward-earnings ratio of around 16.5 times – which is pretty close to where the market was trading around late May.
Of course, if bond yields rise, history suggests equity valuations will be dragged lower. Critical in this regard will be how far inflation in the US, where the labour market is especially tight, lifts from here.
As it stands, US core consumer price inflation has moved from around 1.5 per cent to just over the US Federal Reserve’s 2 per cent target in recent months. That said, the Fed has indicated it is prepared to tolerate inflation a little above 2 per cent for a while, given it had languished below 2 per cent for some time.
So far, at least US wage growth has remained fairly benign, which, along with ongoing competitive pressures in the US economy, suggest inflation is unlikely to get out of hand anytime soon.
Accordingly, my base case is that the Fed will likely lift rates only twice more this year, and US 10-year bond yields will probably end the year not much above 3.25 per cent. Under this scenario, Wall Street can continue to recover in the coming months, with rising earnings offsetting any further drag on valuations caused by higher interest rates.
The last notable risk for markets is the often-erratic leader of the free world, US President Donald Trump. However, again, although he is making trade and military threats in various corners of the world, he’s also shown a willingness to pull his punches when needs be. Although he’ll likely continue to huff and puff, I suspect he won’t ever risk blowing the house down.
Of course, it’s still likely that the easy gains on Wall Street in recent years have largely passed, but provided a wrenching bear market is avoided, it should provide a good platform for certain regions and industries to still reward astute investors.
Where’s the value? Europe and Japan seem likely candidates as their economies have greater spare capacity than the US, and their central banks are likely to retain expansionary monetary policies for longer. Global financials also tend to do well in a rising interest rate environment, while, as noted above, the US technology sector still retains a number of structural tailwinds in its favour.
As for Australia, the overall market may well continue to lag global peers given the rising regulatory risk and slowing credit growth now facing our all-important financial sector. Resource stocks also remain at the mercy of iron ore prices, which appear to be trending gradually downward as China moves to wind back excess steel production. Interestingly, outside of the top-20 stocks in the market, the smaller to mid-cap parts of the market have been posting reasonable performance. Given rising tourism and strong growth in construction and health-related services, it may pay Australian investors to seek growth opportunities in this more dynamic part of the market.