Economic Outlook for February 2017
The prospect of a business friendly regime from the incoming US government has propelled US equity markets to record levels in January. Given the fact that tax and spending plans are still mostly conceptual, and the fact that these plans cannot be implemented by executive orders but have to go through Congress, one can understand that investors might conclude that shares have run ahead of reality and may be tempted to take profits.
Earnings trends are the “reality check” for equity investors. Although occasional volatility cannot be ruled out in the current earnings season, the economic backdrop continues to improve even without additional stimulative US policies: the improvement in Europe is remarkable and incoming data from other regions around the globe increasingly point towards growth acceleration in the course of the year. Equities’ valuations are still reasonable in most sectors (in particular compared to bonds) in spite of the recent rally.
US growth decelerates...
After a gradual acceleration of US economic growth in the course of last year the fourth quarter produced somewhat of a set-back (although the data are merely a first estimate): GDP increased at an annual rate of 1.9% (slightly below consensus projections) compared to the third quarter 3.5% growth rate. The deceleration of the momentum at the end of 2016 can be attributed to an acceleration in imports. It is important to emphasize that, although net imports are a drag in the definition of GDP, an increase in imports does not necessarily imply a weak underlying economy: it merely signals that domestic demand for goods exceeds what can be produced domestically. Encouragingly, fixed investments (+4.2%) and inventory build-up increased although personal consumption weakened moderately (contributing 1.7% to overall growth compared to 2% in the third quarter).
The latest GDP data do not warrant a major reassessment of the positive long-term outlook and the consensus amongst economists is to maintain a growth rate of around 2% for this year and 2018, excluding the additional boost that could emerge from tax and expenditure measures by the Trump administration. Leading indicators support the notion that the US economy probably “took a breather” at the end of 2016: the PMIs for the whole US economy and the services sector both reported strong readings for January 2017, 55.4 and 55.1 respectively, indicating high expectations of expansion. These latest data support the view that economic sentiment has improved in the US since the election, which we can expect to see reflected in economic data from the first quarter onwards.
...but Europe accelerates
Whereas the USA recorded a muted end to 2016, Europe surprised with positive momentum. During the fourth quarter the Euro-zone GDP was surprisingly strong, showing a 0.5% advance on the third quarter, which implies a 1.8% year-on-year advance (for the year the Euro zone grew by 1.7%). The economic tailwind is likely to continue this year based on leading indicators. The European Commission’s Sentiment Indicator, for instance, jumped to a 70 month high in January reaching 108.2. Based on the historic relationship between this indicator and subsequent economic growth this latest reading suggests GDP growth of some 2.5%; a clear acceleration from last year, and ahead of the current IMF forecast (+1.6%).
Global forecasts maintained...for now
Timed to coincide with the Davos World Forum, the IMF published an update on its World Economic Outlook and related economic prognosis in January. The IMF forecasts do not have a favourable track record but represent nevertheless the “best we can get”. The complications of computing short-term forecasts is significantly complicated when economic “regime change” occurs which severely limits the extrapolation with parameters based on recent trends (the basis of econometric models). It seems logical that the IMF economists favour to opt for conservative estimates and, to some extent, reserve judgment on the effects of Brexit and the economic agenda of the Trump administration. The IMF statement states that “...while the balance of risks is viewed as being to the downside, there are also upside risks to near-term growth. Specifically, global activity could accelerate more strongly if policy stimulus turns out to be larger than currently projected in the United States or China.” The IMF currently foresees some acceleration in global growth from 3.1% last year but there seems to be a high probability of adjustments in the course of the year. One could raise a question mark, for instance, with respect to the IMF’s UK forecast (a decline from 2% growth in 2016) which seems to be based on an unusually large number of unpredictable factors. Interestingly, current projections do not foresee a negative GDP contribution from any major economic region and the BRIC economies are back in positive growth mode with accelerating growth in India and Brazil moving out of its recession.
IMF Output Forecasts
(World Economic Outlook, January 2017)
Global equities’ valuation remains reasonable
“Trumponomics” has been a major factor for positive equity returns during January and at the start of the reporting season of 2016 fourth quarter earnings one can expect a “reality check” and, with that, some potential volatility in February. The issue, therefore, is what investors can expect from corporate earnings. Based on the (limited) reports so far one can observe that, with around a third of the S&P 500 companies reporting, some 28% have upgraded their guidance above analysts’ estimates (according to Thomson Reuters). An improving world economy is more likely to result in earnings upgrades and the earnings trend should remain supportive of equities.
The most important factor in assessing the outlook after the recent rally is the valuation of equities. Some argue that, on an absolute basis (for instance by measuring P/E ratios), valuations look stretched (at the high end of historic ranges) particularly in the US market. Of course if profits continue to record unexpected positive surprises the forward P/E calculation might prove to be too high (the P/E could still be reasonable). A relative valuation measure is the Equity Risk Premium or ERP (the inverse of the P/E ratio, or E/P, divided by the long term government bond yield) which indicates the valuation of equities against bonds. There are ranges of estimates of this measure but the authoritative ERP indicator for the US from Aswath Damodaran (Professor of Finance at the Stern School of Business at New York University) currently shows an (implied) ERP of 4.5%, which is slightly above the long term average.
A reduction in the ERP can be achieved by higher share prices (lowering E/P) or higher interest rates (increasing the denominator). On the other hand, favourable profit trends have the effect of keeping the ERP at elevated levels (raising the E/P). Monetary tightening, on its own, could therefore disrupt the equity rally but FED’s Janet Yellen reassured financial markets at a speech on January 19 when she stated that “..the stance of monetary policy remains modestly accommodative, and so policy should support some further strengthening in labor market conditions and thus the return of inflation to our 2 percent goal.” Assuming that the details of tax cuts and fiscal policies will gradually be felt throughout the course of the year, the current best estimation is to expect three rate rises which will be lagging economic trends and, therefore, unlikely to alter favourable growth trends, corporate profit momentum and equities’ valuation (rising E/P likely to boost the ERP equation).
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