Economic Outlook for January 2017
Global Stocks ended the year on a positive note largely inspired by the Trump Rally in the USA and improving economic data around the globe. After a very poor start to the year, when many commentators were predicting a recession that never happened, investor confidence has made a comeback. For the year as a whole, the major indices in Asia (The Nikkei and the Hang Seng indices) were virtually unchanged whilst the Euro Stoxx 50 showed a marginal 0.7% increase (the FTSE is the clear European winner with a 14% jump). The performance of the Dow Jones Index stood out in the US (+13% over the year), clearly out-performing the wider S&P 500 Index (+9.5%) and the Nasdaq (+7.5%).
The worst kept secret of December was the 25bp rise in official interest rates by the FED. Interestingly the market remained calm after the consensus for the number of rate rises rose from two to three for this year. The market seems to accept (maybe even embrace) the notion of monetary policy normalization based on, and lagging, improving economic momentum.
Meanwhile the continued strength in equity markets has left growth stocks behind. This creates an investment opportunity for long term investors as the fundamental trends of key growth themes (such as aspirational spending by consumers and the relentless advance of Ecommerce) continue unabated.
FED accelerating policy normalization
The Federal Open Market Committee (FOMC) of the US FED announced in December that it raised the federal funds rate (the short-term interest rate instrument) by 25bp to a range of 0.25 - 0.75%. The FOMC has been implementing a very slow tightening policy, considering that the first rate rise occurred in December 2015. The normalization stance has recently become more pressing as the FED is coming close to achieving the targets of its dual mandate of maximum employment and price “stability” (an inflation target of 2%). During the press conference, Janet Yellen stated that “ the median projection for growth of inflation adjusted gross domestic product rises from 1.9 percent this year to 2.1 percent in 2017 and stays close to 2 percent in 2018 and 2019, slightly above its estimated longer-run rate”. In addition the inflation target seems to have become within reach, with Yellen explaining that “as the transitory influences of earlier declines in energy prices and prices of imports continue to fade and as the job market strengthens further, we expect overall inflation to rise to 2 percent over the next couple of years.”
Although it was not admitted during Yellen’s press conference, it seems that the incoming president’s plans for a major fiscal stimulus has influenced the stance of some of the FOMC members and it is not surprising that a more robust tightening process (three rate rises in 2017 rather than two) has become the consensus projection. In such a scenario the FOMC would achieve a normalized level of short-term interest rates (around 3%) over a two-year period.
Growth stocks in an attractive “investment window”
The divergent performance of the three major US equity indices since the presidential election reflects significant differences between various sectors. The Dow Jones index is more representative of cyclical stocks whilst the NASDAQ is generally regarded as a proxy for technology and other growth industries. The graph illustrates that after the draw-down at the start of the year, growth stocks (the NASDAQ) caught up with the wider market up to the presidential election in November when sector rotation recurred and resulted in under-performance up to the end of the year.
At the start of 2017 investors can be forgiven for wondering how lasting the under-performance of growth will be and if the upward trend in global equities will spread beyond the US (and UK). Predicting the timing of rotations between regions and sectors is not a precise science but there are strong arguments to adopt a wider positive stance in global equities:
- The global economic momentum is showing a moderate acceleration, making upgrades in economic forecasts more likely in the course of the year;
- Around the world the emphasis of economic policies is moving away from monetary easing towards fiscal stimulation which tends to have a more direct effect on economic demand;
- A large proportion of the policy proposals being considered by the Republican lawmakers (such as tax reform) benefit the general economy rather than merely the sectors that have been leading the Trump Rally;
- After a number of disappointing quarters the earnings momentum is picking up with earnings forecast upgrades in the US reaching the highest level over the last 5 years;
- As a result of the financial crisis the global economy is characterized by abundant liquidity, which can become a driver of economic momentum as confidence continues to be lifted;
- Bonds have definitely lost their investment appeal now that inflation is gradually picking up and the long-awaited Great Rotation out of bonds into equities can be expected to gather pace in the course of the year;
- The equity risk premium (the inverted P/E ratio, or earnings yield, minus long term government bond yields) is still slightly elevated compared to the historic averages suggesting a modest valuation of equities compared to bonds.
The long-term case for growth stocks remains compelling and straightforward: as these companies grow faster than the economy as a whole (as measured by nominal GDP), it logically follows that the shares of these companies should also out-perform wider equity indices. In the short term the positive backdrop for global equities, combined with the under-performance of growth stocks last year, has resulted in an “investment window” of attractive valuations for superior growth prospects. The compression of valuation multiples is most visible if one assesses the ratio of share prices to companies’ free cash flows (FCFs). Free cash flows are our preferred gauge for growth stocks as they provide insights into either the potential for incremental sources of growth (through additional capacity or acquisitions) or additional returns for shareholders (through dividends or stock re-purchases).
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