Global equity markets reacted to the ongoing improvement in the global economic environment over the first quarter of 2017, and we have generally positioned our global equity portfolios toward companies with rising earnings prospects that are not reflected in valuations.
Inflation and Growth More Visible
Headline inflation accelerated across all developed economies in the first quarter as oil prices rose. While headline inflation has peaked, core inflation, particularly in the United States, is back to pre-crisis levels and has been broadly stable since the beginning of 2016. Improved pricing combined with steady growth suggests that we will see acceleration in nominal gross domestic product (GDP) growth, with corresponding improvement in corporate earnings, especially in China.
Bond Market Re-pricing Stalled
Although growth and inflation are more visible, re-pricing in the bond market has stalled. Perhaps failure to repeal the Affordable Care Act highlighted the challenges with advancing an ambitious legislative agenda in the short term. The 10-year yield on U.S. Treasuries was at 2.4% at the end of March, the same level as at the beginning of the year. This helps explain why consumer staples were among the best performers in the first quarter.
At the same time, both the U.S. Federal Reserve and the European Central Bank (ECB)—two of the world’s most powerful central banks—telegraphed to the markets that they would like to see steeper yield curves in line with developments in real economies.
March minutes indicated that the Fed’s Federal Open Market Committee is exploring ways to adjust the share of reinvestments to get a steeper yield curve before the end of 2017. The message from the ECB was that asset purchases have to end before rates begin to increase. In essence, the reduction in monetary accommodation needs to start in the long end of the curve.
Our preference remains for high-quality growth, but we believe the opportunity set has expanded, and some of those companies are in cheaper areas of the market.
Equity Opportunities Expanding
A steeper yield curve matters for equity returns. At a minimum, higher interest rates influence the discount rate for future cash flows.
Valuation sensitivity has increased across geographies and sectors. Looking at the traditional discounted cash flow framework, the three main elements are suddenly working against investors with long-life assets: the terminal multiple is probably coming down, the cost of capital seems to be heading up, and free cash flows are under pressure from protectionism.
In this environment, we have been adding to high-quality companies with lower valuations. Our preference remains for high-quality growth, but we believe the opportunity set has expanded, and some of those companies are in cheaper areas of the market.
Looking Ahead
Despite a near-term pause in bond market re-pricing, we expect to see a continuation of the recent reflationary market environment in 2017.
There appears to be upside risk to nominal growth, so we have generally positioned our global equity portfolios toward companies with rising earnings prospects that we believe are not fairly reflected in valuations.
At the same time, economic expansion favors more active stock selection across all sectors. From a regional perspective, Europe looks more attractive than the United States, where economic expansion is more advanced.
In regard to emerging markets, several factors are particularly supportive. First, valuations remain attractive, even as the overall discount to developed markets has narrowed based on forward price-to-earnings (P/E) multiples. Second, after stagnating the last few years, corporate earnings are forecast to increase at a low-double-digit pace this year.
Finally, from an external balance perspective, emerging market currencies have already depreciated and current account deficits have moderated. But there are also risks in emerging markets: a strengthening U.S. dollar, U.S. interest rate hikes, protectionist measures that impede global trade, China’s capital outflows and currency-management policy, and the lingering effects of India’s demonetization on local economic activity.
We will monitor these developments closely.
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