June 2018: Markets Climb a Wall of Worry

Global stocks resume uptrend and are up 2% year-to-date
Political uncertainty in Italy adds to headwinds hurting European equities
Trade war concerns increase, but still look manageable
Global equities’ valuation slightly above average, but strong earnings growth supports further upside
Investors have poured over 94 billion USD into equity funds and ETFs so far this year

Global stocks recovered from correction, but Europe is lagging

Despite increased volatility, global equity markets resumed the uptrend with most regions recovering the year-to-date losses. Euro-based investors received an additional performance boost from currency moves, as the dollar appreciated against the euro.

The All Country World Index finished May up 2% year-to-date, mainly supported by US equities. Emerging market equities are down 0.5% in 2018, but are up over 8% since May 2017.

European equities have been lagging and are down 1.7% year-to-date. Europe has underperformed already for some time and is now the worst major region in terms of 1-year equity market performance.

Political uncertainty becomes additional headwind for European financial markets

European macro data have continued to weaken this year. Although improving, European corporate earnings growth is significantly lagging other regions. This has been the headwind for European equities resulting in their recent poor performance.

To add insult to injury, political turmoil in Italy has caused additional uncertainty in the EU, as the populist party (MS5) won many seats in the parliament and was having trouble forming a coalition. As a result, Italy had a risk of a snap election, hurting investor sentiment globally.

Although a new election was avoided and a coalition formed, uncertainty remains regarding the economic reforms the new government may introduce. What is more, some of the proposed policies of the MS5 party risk adding even more debt to the already large public debt in Italy (about 132% of GDP). As a result, Italian bond yield spread to German bonds has spiked, while the euro dropped against the USD.

Still, investors should consider that the impact of this uncertainty is local to European markets and should not have any influence on the global economy or corporate earnings and thus global equity markets. European equities, on the other hand, may continue to lag due to this political situation.

However, the resulting weaker euro exchange rate should provide support to European exporters, making their products cheaper and increasing their international revenue. Thus we may see a recovery in European corporate earnings growth.

Trade war issues regain investor attention

With the earnings season coming to an end and economic data being stable, investors’ attention is once again shifting to various political and geopolitical headlines. And there was no shortage of stories covering Italy, North Korea, the Middle East and China. However, the effects of news on the markets was transitory, as such events do not pose any significant influence on the global economy.

However, there is one issue that may become a real worry for investors – trade wars – as this can affect economic growth and corporate earnings. Moreover, we are now entering the phase when politicians move from discussions and negotiations to actual policy implementation. As a result, this issue has lately been regaining investor attention.

Additionally, on the last day of May, the Trump administration unexpectedly delivered a blow to America’s closest allies by imposing tariffs on steel and aluminium from Europe, Mexico and Canada. This decision will most probably trigger retaliatory actions from the affected countries, complicating further negotiations.

Despite that, however, the base case scenario expected by experts is that rationality will prevail and issues will be resolved in negotiations without breaking into a full scale trade war. Consequently, although new headlines on trade war issues may keep volatility high and hurt investor sentiment, no threat to the longer-term equity uptrend is visible at the current stage.

Equity valuation not a concern at current levels

Depending on the specific ratio used, global equities are either fairly valued or slightly above the long term average. According to the widely used Shiller P/E ratio, which measures the valuation against the trailing 10-year average earnings, the All Country World Index trades at 21.7 P/E, compared to its 23 year median of 18.4. Emerging market equities continue to be the cheapest, while the US stock market has the higher Shiller P/E ratio, which is still far from the maximum seen since 1871.

Based on these calculations, current valuation is still far from maximum historical levels. Moreover, during the economic recovery and equity bull market, the Shiller P/E ratio tends to overshoot, as the 10-year average earnings are a lagging measure and do not take into account the projected earnings growth. That effect may be huge, as for example the forward-looking S&P 500 P/E, which takes into account projected 1-year earnings growth, is currently at just 16.5, compared to the average of 25.5 since 1990, making US equities cheap by that measure.

Although both methodologies have their benefits and drawbacks, it is clear that current global equity valuation is neither a headwind nor a tailwind, whatever measure you use. This means that equities are still not too expensive and are still attractive compared to bonds. Moreover, a potential positive earnings growth surprise may provide additional support to equities.

Investors are adding money to equity funds, despite recent volatility

The latest fund flows data shows that investors were not scared by the volatility nor the politics. According to the Thomson Reuters Lipper fund flow data as of 30th of May, investors have poured new money into equity ETFs for the 8th straight week. Moreover, the year-to-date inflow to equity ETFs has reached 67.9 billion USD.

Mutual fund investors were also adding new money to equity funds this year. According to the latest Thomson Reuters Lipper data, equity mutual funds experienced a total of 26.4 billion USD inflows year-to-date.

This is a good indication that investors have been using the latest correction to add to their equity positions at better prices in anticipation of the continuation of the uptrend.

The outlook remains positive

The overall future outlook remains unchanged from previous months. Despite short term fluctuations, global equity markets have managed to climb a wall of worry, as the fundamentals remain supportive of a further upside. While interest rates are expected to continue rising, benign inflation should ensure that the rise will be gradual and slow. Moreover, strong earnings growth is expected to continue.

Trade war issues may result in increased volatility and should be watched for signs of further escalation. However, currently there is no visible threat to the equity uptrend.

Consequently, we are keeping equities overweight in anticipation of the continued uptrend. Equities still offer a reasonable risk premium, while the fixed income performance may be hampered by rising rates.

Within equities, we are increasing our underweight in Europe, due to increased uncertainty, while moving to overweight US stocks due to a very favourable earnings outlook. We are also keeping our overweight in Emerging market equities.

No changes were made in the fixed income positioning. Emerging market bonds continue to offer the best potential. Government bonds are still unattractive, despite the increase in yields.

Atis Krumins
Luminor Private Banking
Head of Investment | Management Department

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