Economic Outlook for May 2017
During April, equity markets have been driven by the election in France, the expectation of stimulative economic measures in the USA and a positive global economic momentum. Interestingly, set-backs by the US government to implement its policy agenda has not led to an equity market correction suggesting that the economic momentum might be a more important driver of financial markets at the moment.
Since the start of the year leading economic indicators around the world (and most prominently in China and the Euro area) have been signaling an improving economic backdrop. The most recent IMF projections represent the first major institutional study corroborating this trend. The global valuation of equities (P/E ratio of around 15 times on a forward earnings basis) represents a reasonable valuation with favourable economic trends feeding through in positive earnings trends. The valuation premium of US equities, rather than indicating “irrational exuberance”, seems to reflect expectations of a profit windfall from tax reform and the high proportion of leading growth companies in the USA (illustrated by the recent out-performance of the NASDAQ index).
Synchronized global growth
The IMF published its authoritative World Economic Outlook in April upgrading global GDP growth forecasts by 0.1% (or $ 126bn) reflecting higher forecasts for the Euro area, China and Russia. An important feature of these projections is the apparent convergence of global growth rates (the difference between the highest and lowest growth rates amongst major economies - India and Brazil - was more than 10% in 2016 and is expected to decline to 7% this year). Another encouraging characteristic is the fact that no major economy is expected to be in recession in 2017-2018 as Russia, Brazil and Nigeria recover from economic down-turns.
For those economists who adhere to “new normal” projections (based on work force and productivity trends) the global economy can be seen as advancing along a structural path: the consistent superior growth in emerging and developing economies (which contribute 70% to global growth according to the IMF) can be expected to lift world growth towards 4% over the next 5 years.
Other highlights of the IMF publication include the 2% global inflation forecast (up from 0.8% in 2016), which is the target for most central banks and suggests that monetary tightening outside the US is rapidly emerging as a major policy theme. It is worth emphasizing that these type of forecasts are not a precise science (the track record of major international institutions is far from perfect) and one should be aware of significant uncertainties of some predictions: the IMF foresees, for instance, an average oil price of US$ 55.2 for this year, and predicts a jump in world trade volume growth to 3.8% (from 2.2% last year). Also, in view of the outcome of lead indicators, the predicted slow-down in Germany seems “at risk” of a further upward adjustment in the next IMF update.
IMF Output Projections
|Emerging & Developing Economies||4.1||4.5||4.8|
SOURCE: IMF World Economic Outlook April 2017
Reasonable valuations & favourable earnings trends
The economic backdrop (higher output and inflation) is of course a principal driver of global corporate earnings trends. The link between economic growth and companies’ profits works through two important channels: sales price rises raise profit margins directly and increased volumes boost the difference between income and fixed costs (operating leverage). These effects are straightforward theoretical concepts but not easy to quantify for individual companies when economic growth accelerates: analysts’ forecasts often under-estimate profit trends during economic inflection periods. At the start of May corporations around the globe are in the middle of the first quarter “earnings season” and provide a useful bottom-up picture of the global economy. Data provided by FactSet show that the so-called blended earnings growth (combining reported earnings with forecasts for companies that have not reported yet) of companies included in the US S&P 500 index reached 12.5% (so far) which is ahead of the 10% earnings growth that was expected prior to the first quarter reporting period.
Positive earnings surprises have been contributing to the positive mood amongst equity investors this year. A number of commentators have started to wonder if the equity bull market can be sustained and point to “rich” valuations of equities in the US market. At first sight the US equity market indeed seems overvalued in a historical context. According to FactSet the forward price to earnings (P/E) ratio for the US equity market stands at 17.4 times, which compares with a 10 year average of 14 times. US equities are also more expensive than the All Country World MSCI Index (by some 13% according to Yardeni Research), which adds to the overall impression of over-valuation. There are, however, credible arguments to modify the headline valuation numbers. Firstly, the US benefits from a higher proportion of superior growth companies (many quoted in NASDAQ) than other global equity markets and can therefore be expected to be relatively expensive on an on-going basis. More importantly, US companies are faced with a possible drastic reduction in corporate tax rates. The proposed decline in the tax rate from 35% to 15% would potentially have a massive effect on profits. For every one Dollar of pre-tax profits a company keeps 65 cents in net profits under the current 35% tax regime, this increases to 85 cents with a 15% tax rate: a 31% jump! To take this simple calculation one step further: if the tax reform were implemented today, the forward P/E ratio of US equities would drop from 17.4 to 13.3 times and be slightly below the 10 year average.
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