Economic Outlook for April
It seems fair to state that the most important political event affecting global financial markets was the failure to replace Obamacare in the USA on March 24. The inability to implement a key policy promise by the Trump administration immediately led to question marks regarding the future of its major economic stimulation package (tax reform and infrastructure spending). This, in turn, created doubt about the sustainability of the Trump Rally in global equities. In the end the market reaction was muted and over the month equity markets showed a mixed performance in the USA (S&P modestly down, NASDAQ modestly up) and continued to rally most other markets (notable exceptions being the UK and Japan).
Earlier in the month the Federal Open Market Committee (FOMC) of the US FED raised the target range for the federal funds rate by 25 bp (to 0.75% to 1%). The market reacted favourably to this second rate rise since the presidential election: it was generally interpreted as a reflection of continued improvement in the US economy. Incoming data and leading indicators provided further support of improving global economic trends and one can conclude that global investors ultimately decided that favourable economic news outweighed political uncertainty.
Global economics vs. politics
The election of Donald Trump occurred against an improving global economic backdrop and the positive economic dynamic has prompted the US FED to increase official interest rates again on March 15. Although the new US administration has not implemented any stimulative policies yet, the incoming economic statistics, and leading indicators, have continued to support the notion of economic tailwinds; it is therefore not surprising that up to two more rises in official interest rates this year are being discounted in US financial markets.
Within the global context the improvement in Europe stood out in March. Strong leading indicators (the Purchasing Managers Indices or PMIs) indicate growth across the region could surprise positively. The economy wide PMI expanded to 56.7, a very strong reading indicating strong expectations of expansion in the Eurozone economy (values above 50 point to future expansion). The Manufacturing and Services PMIs for March were 56.2 and 56.5, similarly indicating very strong expectations of expansion in these sectors of the Eurozone economy. These are the strongest set of PMIs for the Eurozone on record, and the statistical significance of the moves across all three readings suggests a positive change in sentiment in the region. The authoritative IFO Business Climate Index in Germany illustrates the improving momentum at the center of Europe: commenting on the March survey the IFO stated that:
“...The upwards trend in assessments of the current business situation continues unabated. The business outlook for companies also improved again this month. The upswing in the German economy is gaining impetus.”
In view of the significant improvement in leading indicators it seems increasingly unlikely that the German economy will show the slow-down in economic growth that most institutions are still forecasting. The IMF and OECD, for instance, are projecting a slow-down in German GDP growth to 1.7% and 1.6% respectively after 1.9% in 2016: upgrades of economic forecasts for Germany (and the Euro area) look likely.
The positive economic momentum is a main driver of corporate earnings surprises and the continuous adjustment of earnings forecasts to improving conditions implies that existing analysts’ estimates of Earnings Per Share (EPS) are probably lagging behind reality. If EPS estimates were shown to be too low then the forward looking valuation of equities, as measured by the Price to Earnings ratio (P/E ratio), could well prove to be less demanding than some commentators argue, in particular with respect to the US equity market.
So, what evidence of improving earnings trends exists? According to Trading Economics corporate profits in the US market increased by a low single digit rate in the fourth quarter of 2016. A comparison with existing estimates provided by Thomson Reuters corroborates an improving momentum: earnings growth for companies in the S&P 500 index are projected to reach more than 10% in the first quarter this year followed by a similar growth rate in the second quarter (and by 9.5% in Q3 and 13.3% in Q4).
The robust case for Growth Investing
The immediate market reaction to the Trump election was a jump in cyclical stocks (including commodities), as well as the financial sector, thereby out-performing wider equity indices and leaving growth stocks behind up to the end of 2016. Since then, the market performance has widened and it seems that some of the initial sector-rotation has gradually been reversed.
The relative de-rating of growth equities happens during periods of optimism regarding cyclical economic factors. By definition, however, cyclical factors do not persist in the long term and cyclical sectors tend to under-perform the wider market. Growth stocks, on the other hand, benefit from their “log duration” profile: investors can look far into the future regarding the earnings potential of these companies and tend to use the discounted value of long term earnings (and cash flow) streams as a valuation yardstick. As a result, valuations of growth equities tend to be at a premium compared to market averages.
In the current environment of the normalization of interest rates (led by the FED in the US) the discounting of future earnings will, in itself, result in lower discounted values (due to a higher discount rate). This is, however, only one aspect of the economic backdrop: as argued above the earnings trend is likely to be positive and, more importantly, the improving clarity of monetary policy resulting from the normalization process should encourage investors to extend the investment horizon further into the future; increased confidence benefits the risk taking propensity of market participants. It is also worth emphasizing that monetary tightening is only reactive to favourable economic trends (and the related positive earnings momentum). On balance, higher earnings and increased risk taking can be expected to out-weigh the (delayed) effect of rising interest rates.
Temporary rotations within equity markets in and out of growth sectors does not alter the long-term case for growth investing (at a reasonable price): as these stocks reflect companies that grow faster than the world economy (as measured by nominal GDP growth for instance), it logically follows that the shares of these companies should also out-perform wider equity indices in the long run. For the full year the projected average turnover growth for stocks in the Dominion Global Trends underlying assets of the investment portfolios (based on Bloomberg consensus estimates) are above 10% and continue to be in excess of global growth.
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