When Wall Street sneezes the rest of the world catches a cold. It is hard to disentangle my increasing caution about equity markets generally from nervousness about the outlook for US shares. It has been wrong to bet against the S&P 500 ever since the financial crisis but the performance of the US stock market over the past eight years has been spectacular and prudence argues for at least locking in some of Wall Street’s gains.
My first concern is monetary policy. The Fed will remain cautious about raising interest rates but it has undoubtedly set its course towards balance sheet normalisation. By managing expectations, the Fed has avoided a re-run of the 2013 ‘taper tantrum’ but it remains to be seen what happens when the punch bowl starts to be taken away from this month onwards. The good news is that the Fed is attuned to the messages from the markets and will take its foot off the brakes if it needs to.
The second concern is valuation, which looks more stretched in the US than anywhere else. It would be naïve to expect multiples to rise any further from here so only earnings growth can carry the US market higher. At the moment, leading stocks are beating expectations, with companies like Facebook and Apple benefiting from their oligopolistic profits and dominant market positions. They need to continue to do so, which means margins need to stay at today’s historically high levels.
Earnings and margins have held up well in all but the energy sector so we need to keep an eye on interest costs and wage inflation, which pose the greatest threat to returns on capital. The big unknown is what might happen on the taxation front. This was a big part of the Trump narrative earlier in the year but investors may be realising now that they were a bit too gung-ho in promoting this story. Remove the benefit of tax cuts and repatriated profits and valuations really will look demanding.
Thirdly, I’m concerned about the narrow leadership of the market, which means that as much as 50% of market gains in the US are coming from large technology stocks. This is one of the classic signs of the top of a market when investors pin all their hopes on one last hurrah for a favoured sector or theme. There are some early signs of ‘irrational exuberance’ in the second division of tech names, with stocks like Tesla trading on eye-watering multiples. This is where the echoes of the dot.com bubble sound the loudest.
There are some important differences from the 1999 market mania, however. The big tech stocks this time are largely being bought not for their growth potential but for their defensiveness. The FAANG stocks are low volatility, reliable earners with secure anti-competitive moats to protect their businesses. Fear of capital loss rather than blue-sky hopes for capital gain is what is driving the market. One concern might be that tech stocks are vulnerable on two fronts: an acceleration in growth might shift investor interest to value stocks; a slowdown could take them down along with everything else.
The strongest counter argument to this caution is that relative valuations are not excessive. With US Treasuries yielding around 2%, the average dividend paid by a US company looks reasonable. This is an argument for a sideways moving market and an extended, flatter market cycle. As such I’m staying neutral on US equities but grudgingly so.
US shares still matching Treasuries for income
Source: Thomson Reuters Datastream, 28.9.17
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment. For full 5 year performance figures please see Market data.
Select 50 pick: Ian Heslop’s quantitative approach has worked well in recent years and I continue to view the Old Mutual North American Fund as a good way to gain exposure to the US market.
There is no doubt about the principal drivers of the UK stock market at the moment nor how they are related. The sometimes tortuous progress of the Brexit negotiations is a key determinant of investor sentiment while the sterling exchange rate has a mechanistic influence on the FTSE 100. As the pound rises, the stock market’s blue-chip index falls and vice versa.
No surprise then that the recent rise in the value of the pound has resulted in a damp squib of a summer for UK investors. While the US indices have gone on to hit new highs, the FTSE 100 has lost its momentum.
For those parts of the UK stock market that depend on a vibrant domestic economy, the outlook is not great. Consumer confidence, car sales, the dwindling value of real household incomes as inflation rises - wherever you look, things look a bit depressing. Fortunately, investors don’t need to worry unduly about that because so much of the UK market is driven by global factors like the oil price.
The other reason to give UK shares a hearing is the fact that in a world of persistently low interest rates British equities offer a decent income. They continue to have a place in a diversified portfolio but probably not the dominant position that’s suggested by the latest Investment Association statistics. These show that nearly half the money invested in funds in the UK is in UK-listed investments. As I pointed out in my piece on home bias, that’s too high.
Select 50 pick: For the proportion of your portfolio that is invested in the UK, I’m sticking with the balanced approach of the Majedie UK Equity Fund.
Perhaps we should stop talking about European shares as if they were one homogenous group. The chart here shows clearly the massive divergence between the economic engine room of the region, Germany, and the rest. Until the financial crisis the markets did tend to move in lock-step. No longer.
Diverging fortunes within the Euro area
Source: Thomson Reuters Datastream, 28.9.17
Past performance is not a reliable indicator of what might happen in the future. When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment.
What these markets do share, of course, is an exposure to the Euro currency and that has been a significant driver of returns over the summer thanks to the appreciation of the single currency against the dollar - by around 13% so far this year. This is bad news for exporters and overseas earners, which has a particular impact on Germany. Where the Euro goes from here is uncertain. Given the Fed’s determination to focus on its balance sheet rather than interest rates, it is entirely possible that the dollar could weaken even further. This would not be good news for shares on the continent.
The second big influence on markets this year has been the political agenda. At the start of the year, the rise of right wing extremism cast a long shadow over European equity markets. As the year progressed, that worry seemed to reduce. Perhaps the German result recently has rekindled some of those fears.
On the economic front, Europe seems to have reached an uneasy equilibrium. Growth is good but may not get much better. Deflation has been taken out of the equation without being replaced by inflationary fears.
As for valuations, Europe still looks cheaper than America if pricier than Japan. Corporate activity is picking up as a market influence. Correlations within and between sectors has reduced, suggesting the potential for active managers to outperform.
The region is home to many excellent companies, producing goods and services that are in demand around the world. The stock market is a good source of income, too, so we remain positive.
Select 50 pick: Given our preference for more defensive investments at this stage in the market cycle, we continue to like the look of Stephanie Butcher’s Invesco Perpetual European Equity Income Fund.
The Japanese stock market has edged higher in 2017 but lagged other Asian and global markets more recently. In large part this probably reflects concerns about the heightened risk to Japan from North Korea. This sentiment-driven under-performance arguably makes Japan interesting from a relative value perspective, especially when you consider that the risks are binary - either there is no conflict and the worries are unfounded or there is and the level of the Japanese stock market is the least of our concerns.
The under-performance has been most marked among Japan’s large-cap stocks, notably in the automotive sector and among banks. The banks, in particular, look very beaten up, with share prices of less than 10 times earnings on average. This reduces the potential downside, even if rock bottom interest rates and a policy of keeping bond yields close to zero means that the financial sector’s profit outlook remains subdued.
Looking at the macro-economic backdrop, things continue to improve in Japan. The latest GDP growth figures were the 6th positive quarterly reading on the trot, making this the longest continuous growth period for 11 years. Domestic demand is a major driver, with both households and the government playing their part. Exports have risen for eight months in a row, with demand from the US and Asia strong.
Steady if uninspiring growth
Source: Thomson Reuters Datastream, 15.8.17
When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment.
Good growth is feeding through into the labour market, where a 2.8% unemployment rate is the lowest since 1994. The ratio of jobs to applicants is the most favourable since 1974 from the perspective of wage growth, which Japan desperately needs if it is to meet its inflation target. As a result of rising wages, the consumption outlook is improving, helped by the replacement cycle for durable goods, which peaked in 2009/11 on the back of government-funded cash backs on electronic goods and is therefore expected to lead to rising sales again eight years on as items need replacing.
Since the second half of 2016 there has been a notable improvement in corporate earnings, led by manufacturing companies. Revisions continue to be positive. There are more upgrades and companies are beating expectations. Against this backdrop, the Topix index’s average price-to-earnings multiple of less than 14 looks attractive compared with the equivalent of between 15 and 18 in Europe and the US.
There are always things to worry about in Japan. Geo-politics is top of the list at the moment. Demographics are poor as ever. The country is struggling to shake off the deflationary mind-set of the past 20 years or so.
But all this is arguably in the price. The government is stable, with Prime Minister Abe’s approval rating holding up nearly five years after his election and the launch of his ‘three arrows’ of fiscal and monetary stimulus and corporate reform. Growth is improving and feeding through to profits. In a world of stretched equity markets, Japan looks to be a relatively safe haven.
There are two things to watch out for. One is the return of overseas investors, who were net buyers of the Tokyo market in April and May but backed away again when North Korea unsettled markets over the summer. The second key factor is the level of the yen. A strong currency is bad news for Japan's exporters and overseas earners. As a classic haven, it tends to rise when the world looks uncertain.
Select 50 pick: Baillie Gifford is a world leader when it comes to investing in Japan. We like the Baillie Gifford Japanese Fund, which is a great way to tap into the country’s technological expertise, a key focus of the fund.
Asia and Emerging Markets
This has been a good year to be invested in Asian markets outside of Japan. They have performed strongly, with the biggest markets, China and India, leading the charge. The rally has been underpinned by improving earnings forecasts, better than forecast economic growth and a weak dollar. You might have expected this to lead to overseas investors being attracted to the region but it remains off the radar for many investors in the rest of the world.
This may change given the Federal Reserve’s more dovish tone on interest rates as it focuses instead on reining in its bloated balanced sheet rather than raising the cost of borrowing. The fact that Asia is under-owned provides some protection for the region against a market correction.
Dealing with China first, investors have focused here in the wake of MSCI’s inclusion of A-shares in its emerging market indices. That makes sense in the long run, but the strong growth in the Shanghai market is a little worrying, dominated as it is by just a handful of mainly technology stocks like Alibaba and Tencent. Just these two shares now account for more than a quarter of MSCI’s China index. ICBC, the world’s largest bank, is by contrast worth just 4%.
No-one would deny that these are good companies, well-managed and with dominant market positions but they are priced for perfection. Investors expect them to continue to grow earnings at their current red-hot levels of around 50% a year. That’s possible but it is a very big ask and investors therefore, enjoy no margin of safety.
Another slight concern is the way in which the Chinese Government is calling on these leading companies to invest in under-performing state-owned companies. It’s called ‘national service’ and threatens to dilute the quality of the best companies, making it even harder to justify their high-octane ratings.
India is also performing strongly. There are good reasons for this. The country has good demographics, an entrepreneurial culture, an educated workforce and the Government is reforming the economy in many positive ways.
Consistently strong GDP growth
Source: Thomson Reuters Datastream, 15.8.17
When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment. Investments in small and emerging markets can be more volatile than those in other overseas markets.
In the short term, there may be some disruption to the growth story. The new goods and services tax which replaces a number of federal and state taxes with one unified tax could hold back GDP for a while. Banking reforms have also been a bit disappointing. However, the long term secular growth story remains intact and the market remains popular with domestic and overseas investors. It needs to remain so as valuations are quite punchy.
For long-term investors, especially any who are looking to reduce any home bias in their portfolios, an exposure to emerging markets is a must have. The economic growth rates enjoyed in Asia are more than twice those in the developed world. Compounded over an extended period, this can transform returns even before you have factored in the potential for individual stocks to outperform the aggregate growth rate.
Emerging markets are the factory of the developed world. This means they are vulnerable to the ups and downs of demand in their end markets. But as the domestic consumption picture improves at home even this dependence is reducing over time. Political risks are arguably no greater than in the developed world today. A wide variation in valuations means an active approach is essential.
Select 50 pick: Nick Price’s Fidelity Emerging Markets Fund has a simple mantra - high quality at a reasonable price. Over the long run it makes sense to buy the best. Not over-paying ensures the growth is not diluted.