• The US equity market reached a new all-time high, while others showed mixed results
  • Emerging markets continue to struggle due to negative investor sentiment
  • The shape of the US yield curve continues to raise investor concerns, but now is not the time to worry
  • Despite high volatility, allocation to emerging market equities improves the portfolio risk adjusted return
  • Strong global earnings growth is expected to continue, as analysts improve estimates
  • Equities still pay a healthy risk premium and are thus more attractive than bonds

The US equity market reached a new all-time high, while others showed mixed results

Global financial markets finished last month with mixed results. The US equity market has once again taken the lead, buoyed by strong economy and exceptional earnings growth. Confirmation from the Fed President Powell that the economic conditions support the expected gradual pace of rate hikes became the catalyst that propelled the market to new all-time high levels. At the beginning of September, the S&P 500 index was up 8% for the year and within 1% of its record level.

Hampered by political issues and slower earnings growth European equities continued to lag. The European equity index is down 3.7% for the year and around 10% below its record level. Currently negative investor sentiment, however, looks to be stretched. Moreover, indicators show that the economic growth is still stabilised at an above trend level. Political issues, however, are not expected to disappear, impairing sentiment and creating volatility.

Emerging markets continue to struggle due to negative investor sentiment

Sentiment towards emerging markets is still hampered by trade war issues and the appreciating US dollar. As a result, the weakest emerging economies experienced currency crises, where Argentina and Turkey saw massive currency depreciations. Although the problems and their effects were local and contained, the whole emerging market equity index continued underperforming. Emerging market equities were down close to 9% for the year, measured in EUR.

A brief bout of risk-off sentiment in the aftermath of Turkey’s currency depreciation pushed the USD to the highest level in 13 months against the euro. However, the currency pair quickly returned to its latest trading range of 1.15-1.18. Going forward, the path of least resistance looks to be for the euro upside, as the currency is undervalued, economic growth is fairly strong and the ECB should start monetary policy normalisation soon. Consequently, such USD depreciation should reduce the headwind for emerging market currencies.

The shape of the US yield curve continues to raise investor concerns, but now is not the time to worry

August did not bring any major changes in the fixed income space. Benign inflation readings led to a slight decrease in EU and US yields. Flattening of the US yield curve continues to grab investor attention. However, analysis shows that neither the trend nor the current levels of the yield curve are reasons to worry.

Despite high volatility, allocation to emerging market equities improves the portfolio risk adjusted return

The relatively poor performance and high volatility of emerging market equities since the end of the last financial crisis made many question the reasonability of investing in emerging market equities.

The performance difference was even worse if we look at the last year, when emerging market equities declined 4% at the same time as the All Country World index rose over 10%. Price fluctuations are also higher in emerging market equities and historically emerging market equities experience a bear market about once every two years on average.

Analysing longer term performance, however, there is evidence that higher risk is also offset by higher return. Since 1988, emerging market equities delivered an average annual return of 8% compared to 5.6% for developed market equities. Moreover, these two regions do not always move together, which further improves the diversification benefits.

Consequently, adding emerging market equities to the portfolio improves the both the absolute and risk adjusted return (return per each unit of risk). Allocating 20% of the portfolio to emerging markets improves the return by almost 1 percentage point compared to the developed markets portfolio. Moreover, as the increase in risk is very small, the return per each unit of risk grows over 10%.

Strong global earnings growth is expected to continue, as analysts improve estimates

Recent exceptionally strong earnings growth has eased worries about the equity valuation, as growing earnings make equities cheaper. Moreover, global earnings growth is expected to continue at a double-digit pace at least for the next year.

As the tax cut effects wane, earnings growth in the US will moderate. But analysts are still expecting over 13.6% in earnings growth for the year ahead. European earnings are also improving and should grow around 9% during the next year. As emerging market earnings are also expected to grow at 13%, overall global corporate earnings growth should exceed 10%.

Confirming the positive developments in corporate earnings is the number of positive earnings revisions by analysts. Globally, over 72% of expected earnings revisions were positive during the last 3 months. A clear trend of improvement is visible in Europe, where over 78% of earnings revisions were to the upside.

Equities still pay a healthy risk premium and are thus more attractive than bonds

As equities are riskier than bonds, investors demand a premium (additional return) for holding them to compensate for the additional risk. The higher the premium, the more attractive equities are compared to bonds. The risk premium is usually measured as the difference between equity earnings yield and the yield of 10-year government bond.

As US equities currently have the highest valuation, we evaluated their relative attractiveness compared to bonds. US equities currently have a 1.37% risk premium over bonds. Although the premium has gone down since its highs, it is still much higher than the average of 0.14% (since 1962). Therefore, equities continue to be clearly more attractive than bonds.


Our outlook remains cautiously positive, as all the main driving factors support equities. Global economic growth, although moderating, is still strong, earnings are growing and global monetary policy remains accommodative.

Still, we also have to acknowledge the risks – potential trade war escalation and its economic effects and political turmoil in Europe. Although the realisation of those risks has a low probability, investors have to be prepared for higher volatility.



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