Equity returns have been much more subdued of late. Many international and emerging markets are losing ground, although the U.S. continues to deliver gains. After a euphoric start to the year, investors have fretted over the sustainability of profits, given higher U.S. interest rates and a stronger U.S. dollar, while the mounting tension over trade and tariffs has not helped, either. So far, however, economic growth remains broad-based across the world, and although the expansion is no longer accelerating in most regions, corporate earnings are growing at a healthy pace. Indeed, our analysts’ earnings forecasts are slightly higher than they were at our Investors Quarterly in April, led by upward revisions in the U.S. And valuations overall look quite reasonable, especially in emerging markets after recent price weakness. In sum, we see the potential for further gains ahead in global equity markets before the cycle ends.
At previous meetings, risks to our outlook were more diffuse. Today, however, the markets are focused on trade and interest rates as two clear risks to profitability. A full-blown trade war would be a major reversal of the trend toward globalization that has underpinned markets for decades and could have severe consequences for corporate profits, given the importance of global supply chains to manufacturers, a major component of market indices. To be sure, it is difficult for any investor to price the risk of a breakdown in trade, and the impact would vary tremendously by company, so we need to pay close attention. We are also wary of the potential for an adverse market reaction as the Federal Reserve (Fed) normalizes interest rates after a prolonged period of quantitative easing, and the flatter yield curve that we already see has been a warning sign in the past. However, we are hopeful that the Fed’s gradualist approach and concern for investor perceptions of its policy moves will make a negative outcome less likely.
In our Global Equity Views below, the product of our July 2018 Investors Quarterly, we present our investment outlook, discuss market trends and spotlight opportunities and potential risks.
We expect 2018 to be a strong year for earnings growth, although the rate of change will slow from here. Since our April meeting, we again revised upward our developed market forecasts for 2018 and 2019, led by the U.S. and the energy sector. Our analysts forecast a very strong 2Q for U.S. earnings, bolstered by a healthy economy and tax reform; Europe should also be robust, with solid underlying growth still evident. We expect earnings growth to decelerate in 2019, by which point profits will be above normalized trend levels, particularly in cyclical sectors such as semiconductors, energy and automotive manufacturers and suppliers.
During the first half of 2018, growth stocks once again dominated equity returns. While growth equity valuations don’t yet appear excessively priced by past standards, the valuation spreads between cheap and expensive stocks have widened to levels that, when accompanied by signs of market distress, have historically been followed by periods of strong value stock outperformance. Although we don’t yet see indications of such stress, we believe the opportunity for value stocks is building (EXHIBIT 1). One important driver of the widening discount for value stocks is the growing unease that investors have toward older companies likely to be “disrupted” by new technology. Whilst the risks are real, this deep degree of pessimism may well create some interesting opportunities.
And as investors show increasing confidence in the disrupters themselves, the current market leaders are more vulnerable to any disappointments.
EXHIBIT 2 presents a snapshot of our outlook.
The opportunity for value stocks is building as the spread between cheap and expensive stocks widens
EXHIBIT 1: RELATIVE VALUATION SPREAD, 1995–2018
Source: J.P. Morgan Asset Management; data as of June 30, 2018.
The International Behavioural Finance Team’s relative valuation spread shows the median forward earnings yield of the highest-ranked quintile on Value minus the median forward earnings yield of the bottom quintile on Value, divided by the market median forward earnings yield.
Views from our Global Equity Investors Quarterly, July 2018
A subset of survey results are shown for Global Equity Investors Quarterly participants, taken in July 2018. These responses are taken from a quarterly survey, representing 31 CIOs and senior portfolio managers across Global Equities.
Over the past several quarters, many of our investors have seen the best prospects in emerging market (EM) equities. This hasn’t been the case this year; emerging markets have fallen 18% (a very typical event in these markets) from January highs, with the main driver of this year’s sell-off a stronger dollar—always a challenge for emerging markets, given the extent of U.S. dollar liabilities for many countries and companies. This trend has been aggravated, of course, by rising frictions over trade.
The profit outlook, however, remains pretty bright for EM companies, and little changed overall despite pockets of weakness. In our expected return framework, forward-looking returns look better to us than we have seen for several quarters, and, indeed, are slightly above average by long-term standards. More near term, technical indicators have also turned positive. For example, after experiencing heavy outflows, EM ETFs are trading at a discount to NAV, a scenario that has historically signaled buying opportunities. We have found opportunities among domestic-focused companies— particularly within the consumer sector—in the so-called Fragile 5 markets (Brazil, India, Indonesia, South Africa and Turkey). We also remain constructive on China as credit growth has slowed from excessive levels and the prospects for monetary easing have increased, though tariffs are an area of concern. De-risking, not deleveraging, is the trend, we believe.
Elsewhere, we see potential for a better performance from European equity. After a brief period of optimism following last year’s French elections, European stocks have been hurt of late by a cooling in regional growth plus a resurgence in political concerns. At this point, we think risk-reward is interesting in Europe, although the region is being held back by a lack of the mega-cap growth stocks so much in vogue these days.
Our U.S. equity team still thinks their market can hit new highs this cycle, with profit growth remaining very healthy and fixed income yields still low enough to support the key dynamic of share repurchases. The profit cycle is clearly mature and worries over the next downturn will restrain progress, but for now fun¬damentals look strong and it should pay to stay invested.
Many of our investors still find much to like in the financials sector, especially among banks, which benefit from rising interest rates. Valuations remain attractive, and capital is now flowing back to shareholders through both dividends and buy¬backs. Elsewhere, our sector preferences are more nuanced; some of our growth investors are finding the opportunity set much narrower these days, although software remains a pre¬ferred theme. Meanwhile, many cyclical companies aren’t as attractive either after strong outperformance since mid-2016, although there are plenty of exceptions to this.
We do see a growing opportunity in high dividend yield stocks, which our research team sees as finally offering better value. For a long time, dividend-paying stocks looked very expensive, with valuations distorted by the exceptionally low levels of long-term bond yields. But as rates have edged higher, the so-called bond equivalents have seriously underperformed, creating an opportunity to buy more dividend yield-oriented stocks in our global research-driven portfolios.
The prospect of a trade war poses a significant risk to our outlook, not least because it could do serious damage to U.S. corporate profits. That reflects the increasing importance of global supply chains to U.S. manufacturers: Net margin in U.S. manufacturing has nearly doubled over the last 15 years, driven by the offshoring of supply chains. And while the manufacturing sector contributes roughly one-tenth of U.S. GDP, it accounts for a far greater share of S&P 500 earnings. Understanding the true consequences of politically driven surprises and changes to the dynamic of globalization that has been so positive for companies and markets will be a key challenge in the months ahead.
As we have discussed in prior quarterlies, rising interest rates and the unwinding of monetary stimulus also present an ongoing challenge to investors. The Fed is well on the way to policy normalization, and the Bank of England anticipates rate hikes this summer, while the European Central Bank plans to end its asset purchases by year-end and hold off on rate increases until summer 2019. Central bankers plan a very gradual normalization, but a rapid rise in interest rates could have a negative impact across asset classes, including equity markets.