The outlook for global equities is a bit more mixed than earlier in the year. In the past weeks we reduced the equity exposure in our tactical asset allocation (TAA) from a medium to a small overweight. We see continuous upside for the Eurozone and the Japanese market but we feel less comfortable with the US market.
Fed’s past rate hikes have not kept markets from gaining
US drivers are running out of fuel
Since March 2009, when US stock markets bottomed out and the S&P500 sank to a sinister intraday low of 666, equities have risen threefold. Three strong forces drove their comeback. First, earnings growth recovered and margins of non-financial companies rebounded to historic highs. Second, monetary policy became extremely easy. As central banks’ balance sheets expanded, valuation metrics increased and kept the equity risk premium at high levels. A third support factor, closely linked to the first two, has been the contraction of high-yield and investment-grade spreads.
Today, however, these three drivers appear to be losing steam, at least in the US. Earnings growth in the US is likely to slow to a nearly negligible 1% in 2015, followed by a sluggish 5% in 2016. These figures pale in comparison with the Eurozone and Japan, where we expect double-digit earnings growth this year and next.
Squeeze on profit margins
US corporates are finding it more and more difficult to increase their profit margins. A stronger dollar and still-weak export markets are hampering revenue growth for exporters, and an improving labour market means that wage growth is likely to erode the bottom line.
Inflationary pressures stemming from the labour market could force the US Federal Reserve to begin hiking its policy rate sooner rather than later, while the further dollar appreciation that a rate hike might trigger would put more pressure on the exporters. The Fed will need to act with finesse to avoid creating market turbulence.
Tighter money, lower valuations
History has shown that policy-rate increases need not stop the market from moving higher after an initial correction; lower valuations caused by tighter monetary policy have in the past been compensated by higher earnings growth (see chart). But when the Fed starts its imminent hiking cycle, earnings growth will probably be too weak to serve as an offsetting factor.
In our base case the Fed will hike in September, but the uncertainty of this timing is high. Fed Chair Janet Yellen’s recent references to the lofty valuations of US equities and the risk of sharply higher bond yields show that she is well aware of the potential market impact of her decision. We share her concerns.
Between a rock and a hard place
The US equity market looks to be between a rock and a hard place. Either the economy strengthens and the Fed hikes interest rates, pressuring valuation metrics, or the economic recovery falters, which would have a negative impact on earnings growth. Given the current state of margins, that would imply an outright earnings decline. Neither outcome is very appealing, but from a medium-term perspective we prefer the first. Lower valuations and stronger macro data would narrow the gap between market performance and the trend in the underlying fundamentals. In other words: valuations would become more attractive.
On a price/earnings basis, US valuations are at their highest in more than 10 years. This is also true for Europe, but given the outlook for higher earnings growth and continued loose monetary policy, European equities are trading at a discount of more than 15% relative to the US in absolute terms.
Private investor sentiment also signals caution on US
We are not alone in our cautious outlook for US equities. Private investor sentiment has fallen to the lowest level since April 2014. Even more interesting is the number of investors that fail to express a view, which is at multi-year highs – a good reflection of the current contradictory forces influencing the market.
While we underweight the US market in a global equity portfolio, we maintain a positive view on developments in the other developed markets, where we see a benign combination of stronger earnings, easy monetary policy, structural reforms and – in the case of Japan – a behavioural shift towards a more shareholder-friendly corporate policy. This is largely a consensus view, evidently. Equity flows are negative for US equities, positive for Europe and accelerating in Japan. Investor positioning points towards an overweight of Eurozone and Japan, to the detriment of the US.