Investment markets and the economy - Jun18

A quarterly update
Source: Russell Investments Australia Limited

Asia Pacific: The pause that refreshes

Economic activity in parts of the region has taken a breather in recent months. However, we believe this is temporary and growth will return through the rest of the year.

The fundamentals in Asia Pacific remain intact. Economic growth looks resilient at mid-year after having decelerated in the first half of 2018. Corporate earnings expectations are in an upgrade cycle for many countries in the region.

China: There were concerns in China around their debt levels and the potential for trade negotiation escalations placing pressure on equity markets. But the Chinese economy continues to be on a good footing. Private investment is growing, and it is likely that we will see an increase in Chinese government spending to further boost activity and confidence.

India and Indonesia: Developing Asian economies have managed to weather the storm of rising U.S. interest rates and a rising U.S. dollar much better than their counterparts in Latin America and Eastern Europe. India and Indonesia have each raised interest rates, which we view as a combination of defending the currency and acknowledging economic activity. Overall, the elevated level of trade within the region, combined with our outlook for China leaves us with a positive outlook for developing Asia.

Australia: Economic growth in Australia is solid, underpinned by public investment, external trade and buoyant business confidence. We see the potential for positive earnings, particularly in mining and resource companies. We view the weaker-than-expected labour market as temporary and expect to see a rebound in the second half of 2018. This should support the Australian consumer, who has been cautious given high levels of debt and muted wage increases.

Japan: has seen very strong earnings growth, the first signs of decent wage growth, a strong labour market and robust business confidence. On the other hand, weak consumer confidence has translated into poor retail spending and household consumption. Rising oil prices are not great for a country that imports nearly all its oil. We expect consumer confidence to rebound as higher wages flow through to household balance sheets. However, further increases in the oil price will be a drag and overall upside for the economy is limited from here.

Investment Strategy

Business cycle: We expect broad-based growth and positive earnings revisions for the region, with a preference for developing Asian countries over developed ones.

Valuation: Valuations are fair priced to slightly attractive across the region. We continue to like Japanese valuations. Australia is close to fair value in our view and developing Asia looks attractive.

Sentiment: Momentum has been taken out of the market recently, in part due to the rising U.S. dollar. The economic surprise index as shown in the chart below is fairly neutral for Asia-Pacific ex-Japan. We would expect this to firm over coming months, which should be positive for regional equities.

Citi Economic Surprise Index

Conclusion: We expect to see solid performance out of the economic data and equity markets in the region, underpinned by strong Chinese activity, robust global growth and supportive policy. We should see positive earnings revisions across much of the region, which should boost equity markets. An escalation in trade tensions or further strengthening in the U.S. dollar remain key risks.

> Read Russell Investments' 2018 Q3 Asia Pacific update

 

United States: Rhythm & Risk

The U.S. economy and corporate earnings have found an upbeat rhythm in 2018. Markets have observed that strength and projected it well into the future. We see healthy fundamentals persisting for the next 12 months. However, as previously mentioned, we see significant risks lurking just beyond the horizon.

Rhythm

We believe the big fiscal stimulus package from President Trump and the Republicans should keep the economy humming along, with above-trend growth through the middle of 2019. Against this backdrop, the Fed is likely to continue hiking rates to prevent the economy from overheating.

US Labour Market

Risk

Evaluating the significant risks clouding the medium-term outlook, we believe the biggest threat is the prospect of a global trade war. We've seen very little adverse impact from trade on the economy thus far, but an escalation toward protectionism could quickly threaten the hiring and capital spending plans of U.S. (and global) businesses.

As previously mentioned, we see the possibility of a U.S. recession becoming much more elevated in late 2019 and into 2020. At this point in the cycle:

  • we expect the Fed will have already moved to a restrictive policy setting,
  • the boost from tax reform and fiscal stimulus will dissipate, and
  • medium-term vulnerabilities from both an overheating labour market and elevated non-financial corporate debt levels will impact the recession outlook.

Investment Strategy

Business cycle: Neutral. Corporate profits have come in ahead of schedule as a stronger global cycle, dollar weakness, and corporate tax cuts helped U.S. businesses deliver 25% earnings growth in Q1 2018.

With the U.S. dollar firming more recently and with a modest stepdown in the global cycle year-to-date, we expect profit growth to gradually taper going forward.

Valuation: Very expensive. The cyclically adjusted Price-to-Earnings ratio for the S&P 500® Index — commonly called the Shiller P/E ratio — stands at 32x. This is its highest level outside of 1929 and the late 1990s. We expect total return on U.S. equities over the next decade to be very subdued – at only about 2% per year.

Sentiment: Neutral. Price momentum has moderated, and we do not currently see any strong indications of either greed or fear in financial markets.

Conclusion: We maintain an underweight preference for U.S. equities in global portfolios, primarily on the back of their expensive valuations. Our underweight preference for U.S. government bonds and interest rate risk from prior years has shifted to neutral.

> Read Russell Investments' 2018 Q3 U.S. update

 

The eurozone: Push & Pull

The push and pull in eurozone markets continued unabated in the second quarter of 2018. From currency moves and changes in the fundamentals to political upheaval, we saw both sides of the equation on almost everything that moves markets. In the end, eurozone financial markets were able to advance modestly, and we expect further gains in the second half of the year.

The Push

Economic growth in the eurozone, despite a modest slowdown, remains robust and corporate earnings are advancing at a healthy pace. In both cases, we have seen growth rates step back from the upper end of our expected range for 2018, to the middle. This is not overly concerning because confidence is strong and profit margins are improving.

The return breakdown of the eurozone equity market in the chart below shows how these fundamental drivers of return have dominated overall returns, without the help of higher valuations. We see this as a comforting return profile with plenty of upside potential.

MSCI EMU Drivers Chart Eurozone

The Pull

Opposite the drivers pushing eurozone financial markets higher, are the forces pulling them lower. First and foremost is political risk. We have worried about Italy for more than a year now, and in the past few months we have been reminded why. We are cautiously optimistic that the constraints imposed by President Mattarella and financial markets will keep them in check. As such, for now we think the risk is manageable.

The Brexit negotiations between the UK and the European Union are not going all that well. The UK struggles to come up with solutions to problems posed by, for instance, the Irish border. We still expect an agreement will be reached to implement a two-year status-quo transition period. However, we worry about the UK’s internal political fragility in getting there.

Investment Strategy

Business cycle: GDP growth has cooled from a level close to the upper end of our 1.8 - 2.4% range to the middle. The same has happened in corporate earnings growth in our 5 - 10% range for 2018. This slowdown, combined with increased political risk, has caused us to lower our business cycle optimism.

Valuation: Equity valuations are neutral while core government bonds are long-term expensive. We decided to slightly alter our range for core bond yields from 0 - 0.8% to 0.2 - 1.0%. This lines up with the low point in yields during the Italian political flare-up. We went underweight Italian bonds in April and moved to overweight subsequently in two steps when valuations jumped from expensive to cheap.

Sentiment: Sentiment for core and peripheral government bonds has been very volatile. It's moved in opposite directions to respectively overbought and oversold levels.

Conclusion: We continue to favour eurozone financial markets over U.S. markets in particular. The push from strong fundamentals, relatively attractive valuation and supportive monetary policy will likely combine to outweigh the pull from increased political risk.

> Read Russell Investments’ 2018 Q3 eurozone update