Investment markets and the economy - Mar18

A quarterly update 
Source: Russell Investments Australia Limited

ASIA PACIFIC: And the show rolls on
We continue to expect solid growth and low inflation out of Asia Pacific in 2018. The Chinese government’s economic growth target indicates another solid year, which we anticipate will be achieved with some mild attempts at reforming the economy. We expect the Japanese and Australian economies to continue to tick along. A move by the U.S. toward protectionism is a key risk to the region. 

Global growth and an expanding middle class in the region are outpacing concerns around high debt levels, notably in China. 

Earnings expectations for the Asia-Pacific region (excluding Japan) remain modest and achievable in our view, and we expect to see positive forecast changes in coming months. As always, the risk of a China slowdown remains, which is being addressed through government intervention.

The Chinese government has announced that growth will continue to roll on, reiterating its 6.5% GDP growth target for 2018, albeit with a slightly tighter government monetary intervention. Looking at other developing economies in the region, the outlook remains positive. In South Korea, a tight labour market has translated into increased consumer confidence and robust retail sales growth.

In Australia, our ‘good, but not great’ theme continues for the economy. The main development is the economic gap that is now in place between the U.S. and Australia, which is something that we haven’t seen in some time. It is likely that this will remain through the year, given our view that the Fed will raise rates at least three times this year, while the Reserve Bank of Australia is expected to raise them just once. This should place some downward pressure on both country’s currencies over the medium term.

In Japan, we believe that Q4 GDP hid the strength of the Japanese consumer and a positive investment outlook. Buoyed by the tight labour market, and some very early signs of wage growth, we are seeing an acceleration in consumer spending. On the business side, elevated confidence and higher production should see a pick-up in investment, while 2020 Olympics-related spending should ramp-up in coming quarters.

Investment Strategy
Business cycle: Look for developing economies to continue to lead the way, with growing support from Australia (underpinned by public investment and a pick-up in consumption) and Japan (supported by very accommodative policy and Olympics-related stimulus). We anticipate positive earnings for the region, focused in the developing countries.

Valuation: Valuations within the region have become slightly less expensive following the fall in value of Asian shares in February 2018. Within the region, we believe Japan offers the best value, while China mainland valuations are attractive.

Sentiment: We have seen a deterioration in momentum, although it remains positive for the region. Equity flows remain healthy, indicating that there is still demand for Asian exposure from global investors. 

Conclusion: We believe Asia-Pacific economic data and equity markets should see another solid year of performance as global growth underpins demand and Governments’ monetary policy remains relatively flexible. Valuations are looking less expensive following the February sell-off, with Japan standing out as offering fair value. A negative turn in the current U.S.-China trade discussions stands as a key risk.

> Download Russell Investments 2018 second quarter update (PDF, 272KB)

United States: Tug of war & trade war
Congress is expected to inject a lot of fiscal stimulus over the next two years. The Fed’s job will be to carefully take that away to prevent risks of an overheating economy. This late-cycle tug of war between fiscal policy and monetary policy is highly unusual. We believe the outlook for the U.S. economy and corporate profits in 2018 is strong, but the challenge for markets is that this optimism is already priced in. We maintain a lower preference for U.S. equities and see better value in other regional markets.

Tug of war between fiscal and monetary policy
President Trump has signed two fiscal stimulus packages since Christmas 2017. The first – the Tax Cut and Jobs Act of 2017 – significantly lowers the tax burden on corporations and high-income individuals. This bill should help U.S. corporate profits in 2018. 

The second – a two-year budget deal signed in February – allows for large increases in discretionary government spending in 2018 and 2019. Taken together, this stimulus is significant; and it’s larger than the tax cuts that President Bush enacted to combat the recession in 2001 (see chart below). On the back of these developments, we have raised our 2018 forecasts for real GDP growth (to 2.6%) and S&P 500 earnings growth (to 12-15%).

Graph: Late-cycle stimulus of this magnitude is highly unusual

However, two factors prevent us from becoming more optimistic about the cyclical outlook for U.S. equities.
• Industry consensus expectations for the U.S. economy and corporate earnings have soared in recent months, suggesting subdued returns ahead.
• Injecting more growth this late in the expansion comes at a price – namely, faster inflation and a faster pace of Fed tightening. In his first testimony as Fed Chair on Feb. 27, Jerome Powell sounded more confident about both the growth and inflation outlook and hinted that the Federal Reserve may now be on track to raise rates four times this year. Against the backdrop of what is already a full employment economy, it will be the Fed’s job to take away this stimulus to prevent the risk of overheating. Longer-term Treasury yields have moved up in sympathy with these concerns to their highest level since early 2014. At 2.8%, 10-year U.S. Treasury yields are now in-line with our estimate of fair value.

Investment Strategy
Business cycle: Corporate profits have come in ahead of schedule as a weak dollar and stronger global cycle helped U.S. businesses deliver 15% earnings growth in Q4. We expect earnings growth to hover around this same, strong level in 2018 given the positive tax reform. The challenge: business confidence has shot up to 20%, increasing the risk that a good earnings year will still end up as a disappointment for markets.
Valuation: U.S. equities remain very expensive. The Shiller P/E ratio for the S&P 500 stands at 33x – its highest level outside of the late 1990s. 
Sentiment: Positive momentum is offset by some evidence that U.S. equities have re-entered overbought territory. 

Conclusion: We continue to have an underweight preference for U.S. equities in global portfolios. With 10-year U.S. Treasury yields hovering around our 2.8% fair value estimate, we move back toward a neutral preference on U.S. government bonds for the first time in several years.

> Download Russell Investments 2018 second quarter update (PDF, 272KB)

The eurozone: Stuck in the middle
The eurozone is still enjoying a mid-cycle renewal, but its financial markets continue to struggle with euro strength. It is stuck between two competing forces. However, the impact of the euro is weakening as we move into the second quarter of 2018 and the economic fundamentals are as strong as ever.

Euro tomorrow
As a rule, when we write about our preferred equity regions, we focus on returns in local currency terms. In the case of the eurozone and the euro, the outlook for the currency was impacting our investment stance. In fact, we take long term views on both equities and the euro to reflect the positive impact the strong cycle developments were having on both.

Nevertheless, we have been surprised by how much euro strength has impacted the equity market, indicated by the relative performance of small vs. large companies’ shares. Small companies are less sensitive to currency swings, because the bulk of their business is conducted regionally and therefore denominated in euros. By the same token, they are also more sensitive to regional economic developments.

Since the start of 2016, small company stocks (small caps) have outperformed large company (large cap) stocks by almost 14 percentage points in euro terms (see chart below). Additionally, eurozone small caps have outperformed global small caps by almost six percentage points in local currency terms. That means that small caps were able to outperform in the face of an 8% rise in the trade-weighted euro exchange rate (and a 17% rise vs. the U.S. dollar). Clear evidence in our view that strong fundamentals matter. But in the case of large cap equities, these were simply outgunned by the currency effect.

Graph: Eurozone small-cap stocks outperform amid competing cyclical forces 

Investment Strategy
Business cycle: Strong GDP growth has allowed us to upgrade our expectations. We expect the European Central Bank (ECB) to stay accommodative and less aggressive this year. Corporate earnings growth of approximately 5%-10% is robust.

Valuation: Eurozone equity valuations are neutral while core government bonds are long-term expensive. Our expected range for core bond yields at 0%-0.8% is unchanged, although we would be surprised to see the low end of that range again. Still, a significant breakout from that range remains unlikely given ECB bond purchases and lack of inflation in Europe. 

Sentiment: Our sentiment score for eurozone equities is in slightly negative territory. Sentiment for government bonds has gone from neutral to positive. 

Conclusion: We continue to favour eurozone financial markets, particularly over U.S. markets. Strong fundamentals and relatively attractive valuations underpin our view, while sentiment is currently not a differentiator.

> Download Russell Investments 2018 second quarter update (PDF, 272KB)