The 2008-09 global financial crisis cast a very long shadow for investors and company managements alike. But that shadow is finally lifting, and equity markets have been boosted by a potent mix of strong global growth, robust profits, subdued inflation and still very low interest rates. A synchronized global recovery is in full swing, and we expect the strong corporate earnings growth we saw last year to be repeated in 2018 and 2019. In the U.S., corporate tax cuts are providing an extra gust of tailwind to an already bright and breezy picture.
The return of volatility appears almost a certainty after one of the calmest years on record, and periodic setbacks are almost certain, as well. But we believe that market gains can broadly continue until interest rates rise much further and/or a recession appears on the horizon. As bottom-up stock pickers, we are still finding good opportunities in emerging markets, financials and cyclicals. The main risks that we see are centered on the transition to less accommodative monetary policy, a transition now underway in the U.S. But stocks still look to be a good value vs. bonds, and overall we expect this transition to be weathered pretty well over the next year or so.
In the following pages of our Global Equity Views, we present our investment outlook, discuss market trends and spotlight opportunities and potential risks. EXHIBITS 1 and 2 present snapshots of our outlook, as they were discussed and debated at our Investors Quarterly in January 2018.
Views from our Global Equity Investors Quarterly (January 2018), Part I
A subset of survey results are shown for Global Equity Investors Quarterly participants, taken in January 2018. These responses are taken from a quarterly survey, representing 26 CIOs and senior portfolio managers across global equities.J.P. Morgan Asset Management estimates shown as of January 12, 2018, for the J.P. Morgan Asset Management developed market equity coverage universe. Forecasts, projections and other forward-looking statements are based upon current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecasts, projections and other forward statements, actual events, results or performance may differ materially from those reflected or contemplated.
Views from our Global Equity Investors Quarterly (January 2018), Part II
A subset of survey results are shown for Global Equity Investors Quarterly participants, taken in January 2018. These responses are taken from a quarterly survey, representing 23 CIOs and senior portfolio managers across global equities.
We believe that the upswing in global corporate profits that started in mid-2016 still has further to run. The depth and breadth of global growth, manifest in multi-year highs in manufacturing purchasing managers’ index (PMI) figures, has become self-reinforcing, while typical late-cycle inflationary pressures have not yet appeared. In the U.S., our analysts forecast a remarkable 18% growth rate this year, driven by both tax reform and strong underlying fundamentals. Profits in Europe, Japan and the emerging markets are still at an earlier stage of recovery, and our analysts are confident that this uptrend will continue. Corporate confidence is improving, too: We see an increasing propensity by company managements to boost both capital spending and hiring.
Equity valuations are obviously much less compelling after the gains of the past year, but strong profit growth has helped keep price/earnings ratios in check, while comparisons with bond markets are still very favorable. U.S. equities look the most highly priced of the major regions, but even here the relationship with bond yields is still unusually supportive of stocks and will remain so until 10-year Treasury yields are closer to 4%. Meanwhile, we note that markets typically perform very well in the later stages of a business cycle, although volatility starts to rise as the risks of disappointment increase.
Although we expect that all markets will likely participate in further gains, we still see the best prospects in emerging markets. The macroeconomic view is always especially important in emerging markets, and the current picture looks very positive, with a broad and accelerating recovery coupled with still-subdued inflation. Profits were up over 20% last year, and our estimates suggest another couple years of good growth ahead. The MSCI Emerging Markets Index is still slightly below the highs reached in the last cycle (while the S&P 500 is around 70% higher than its peak in 2007), and the valuation measures that we follow are less extended than in many developed markets. At the same time, the market’s attention is now moving beyond the mega cap technology heavyweights to a wider range of stocks—a healthy development. The opening of the China A-share market to increasing foreign participation is an important change, adding a large number of highly liquid stocks to the emerging market (EM) opportunity set.
In Europe, profitability has finally started to improve after several disappointing years, and we see plenty of room for this to continue. The economic backdrop looks much better, with regional PMIs at healthy levels; European companies, with their typically high operating leverage, are especially exposed to faster global growth. The European banking sector looks much better, too, these days, with stronger balance sheets and a recovery in loan growth now evident. We are watching closely the rise of shareholder activism in Europe, given the considerable potential to improve capital discipline and shareholder returns across many larger cap companies in the region. Despite a more positive market in the past year, investors have been net sellers of European equities over the last decade, and there is more room for recovery in risk appetite for the region.
Although financial stocks have performed well over the past year, we still see further upside across most markets. The sector is now benefiting from a number of positive trends, including much improved balance sheets, rising profitability as economies accelerate and interest rates move higher, and more ability to return capital to shareholders in the form of both dividends and buybacks. Valuations are still sensible for the most part, even after recent gains.
Despite considerable underperformance over the last year, most of our investors still have little interest in bond proxies—those sectors, such as consumer staples and utilities, that have been most correlated with movements in bond yields. Many of these stocks still look expensive, and in many cases profits are not very exciting, either. More controversially, after an exceptional run, technology stocks look more fully priced to us as well, and the fundamental outlook for one or two of the highly favored internet stocks may be a little less exciting in the future. As a result, our investors have reduced exposure to some of the brightest technology stars.
With the economic outlook clearly so much brighter, investors have become more aggressive in recent months, and some of the traditional warning signs of overconfidence have begun to appear: Equity fund flows are hitting new records, and individuals are trading their brokerage accounts much more actively. What can go wrong?
Higher interest rates appear to be the most likely source of angst. Developed market central banks are in the early stage of balance sheet normalization; 2018 is the year in which net purchases by G4 central banks begin to decline. Although central bankers plan a very gradual normalization, there is, of course, a risk of unexpected market disruptions. If inflation finally begins to accelerate, the move to higher rates could quicken. Amid strong growth and tightening labor markets, inflation has been remarkably quiescent for a long time. But as labor slack dissipates and output gaps close, that could change, posing a risk to asset returns.
The chances of a serious disappointment in economic growth appear remote right now, with our recession watch indicators all sending very benign signals. We will, however, continue to monitor the prospects of a China slowdown. The Li Keqiang Index, an alternative measure of China’s economy, declined last year, while the Chinese equity markets moved higher. The global economic recovery and astute domestic policy decisions have kept China on a growth path, but there are still risks here.
The most obvious call is for a return of volatility in 2018, after a year in which pretty much everything went right and stock prices went straight up around the world. History suggests that this exceptionally benign relationship between return and risk is not going to persist and that investors should accept and prepare for a rougher ride. But a serious breakdown in equity markets seems unlikely until interest rates move much higher and the end of the business cycle comes into view.
As the shadow from the financial crisis has finally lifted, equity markets are enjoying the benefits of strong, synchronized global growth—a welcome backdrop for robust corporate profits. We see plenty of potential for profits to keep growing, but higher interest rates are bringing volatility back to the world’s stock markets in 2018. Emerging market, financial and cyclical stocks remain our favored investments.