Economic Outlook for February 2018
2017 was a strong year for global equities and 2018 started in a similar vein, with low volatility and steady positive price momentum for global equities through most of January. The spike in volatility in the final trading days of the month and short-term sell-off in the S&P 500, which declined 1.4% in two trading sessions and included the biggest single day decline in the index since August, has reminded investors that the record low volatility levels and stable positive equity price momentum enjoyed over the past six months cannot be expected to continue ad infinitum. Corrections in prices do happen and will occur again, they are an inevitability in equity markets. The question for investors in 2018 is how to react, if at all, to these inevitable market perturbations.
Equity markets are not abstract entities, they are driven over the long-term by the fundamentals of the real economy, and it is here that investors should be looking for direction. Underlying economic fundamentals and long-term structural demand trends continue to support the case for owning equities, particularly equities with exposure to these global trends. Economic data for the World’s major economies has improved significantly through 2017, global growth forecasts are being revised upwards and corporate earnings growth is accelerating. Earnings for the S&P 500 are expected to increase +12% YoY in Q4 2017, 80% of the companies that have already reported full-year results have beaten expectations. Economic confidence indicators in the US and Europe are at record highs. Meanwhile inflation remains low, Eurozone inflation in January declined to 1.3% while US inflation remains subdued, indicating we are still in the early- to mid -phase of the business cycle. The so-called Goldilocks scenario for the global economy continues.
Context is everything and the context for equity markets in 2018 is positive, driven by the improving fundamentals of the global economy. Investors should not become over familiar with low volatility and steady prices, even a normalisation to historic levels of volatility may appear abnormal given how low volatility has been in recent months. But a normalisation of equity market volatility should not be confused with an inflexion point in the bull-market. So long as the fundamentals support valuations, equities will remain an attractive investment.
A Return to ‘Business as Usual’
Perceived sources of geopolitical and economic risks are subsiding. The expected political earthquakes in the Western World caused by Brexit and the election of Donald Trump in the United States have not resulted in any measurable negative impact on the global economy, despite the dire predictions of many economic commentators. Elections in the Eurozone’s two largest economies, France and Germany, have put the populist threat to bed for at least another four years. Tensions on the Korean peninsula have subsided. It appears the fear mongering of the 2016-2017 period may have been exaggerated, and this has given way to the economic reality that the global economy continues in ‘business as usual’ mode, steadily accelerating to the highest rates of growth since before the financial crisis. As perceptions of exogenous risk factors to the global economy become increasingly distant memories, sentiment is likely to shift towards a more realistic view that the global economy is in a strong position and growth is accelerating. The decline in volatility and steady rise in equity prices of 2017 make sense when viewed through this prism.
As the major central banks of the world edge toward reducing monetary easing and in some cases begin to raise interest rates, the unsurprising outcome is rising sovereign debt yields. US Treasuries have led the rise in yields (and decline in price) for government debt, with 10-year notes now trading on a yield greater than 2.7%, the highest since 2014. Again, many doomsayers are pointing to the bond market as a source of existential risk for equity markets. If bond prices keep falling and yields rising, they say, this could impact equity markets severely. This view is missing the point. The return to normality for monetary policy is a reflection of the strengthening fundamentals of the global economy. The reality of ‘business as usual’ for the global economy is the driver of the rise in rates back to a more normalised long-term level.
Higher interest rates do have a negative impact on equity valuations. The process of reducing equity risk premiums and increasing the discount rate, by definition, must have a negative effect on equity valuations. However, the context of the interest rate rise is critical for taking a view on direction of equity prices. Steady normalisation of rates supported by accelerating economic activity and low inflation characterise an environment of high corporate earnings growth and positive equity price momentum. On balance, positive effect from the acceleration of the global economy and corporate earnings through 2018 is more likely to outweigh any negative valuation impact to equities from higher bond yields.
Growth in Major Economies Remains Strong
The underlying economic fundamentals for the major economies of the world have continued to improve, and as such continue to support equity market valuations.
In the US, economic confidence remains high, while the industrials sector and retail sales continue to accelerate. US retail sales growth rates have accelerated to close to +6% YoY, US industrial output in January moved past +4% growth, and economic confidence indicators remain at levels significantly higher than at any time since 2008. The UoM Consumer Sentiment Index maintained its high absolute level in January, indicating consumer confidence remains elevated. PMIs for the US economy for January remain elevated, indicating high expectations for expansion in the whole economy, particularly in the services sector. The Bloomberg US Economy Consumer Expectations Index posted a strong rise in January 2018, indicating strong consumer outlook is being maintained.
In the Eurozone, economic expectation surveys are hitting record highs and continued to accelerate in January, indicating underlying activity is expanding at a faster rate. New data shows further acceleration in expectations of activity improvement in the Eurozone. PMI releases for January show elevated levels of outlook and statistically significant increases in expectations. The Manufacturing sector PMI remains at its elevated level at the beginning of 2018, continuing to indicate strong expectations of expansion in activity in that sector in the Eurozone.
In China activity levels remain robust. The latest data continue to show a positive picture for activity levels. The China Satellite Manufacturing Index, an independent data source from outside China, posted a strong rise in its reading for January, indicating a solid increase in underlying economic at the start of 2018. The Li Keqiang Index (a weighted index of high quality China economic indicators) posted another strong reading in December, continuing to indicate the Chinese economy has recovered in a robust fashion from weaker activity levels in 2016.
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