Equities – a regional perspective

US

There are reasons to be both positive and negative on the US market. On balance, the headwinds are likely to outweigh the tailwinds, however, and we think there are better opportunities elsewhere in the world.

The first reason to be positive about the US is its relative defensiveness. The high quality of American companies, their high margins and the speed with which they can protect profits by cutting costs, make America a safe haven if you think that the recovery might falter this year.

Secondly, the US dominates technology, which continues to look like a market leader in 2018 as the promise of the internet revolution is finally delivered. Partly thanks to technology, earnings revisions in the US are positive.

Thirdly, tax reforms have the potential to lift profits at US companies and to encourage those who have parked profits overseas to repatriate them and probably return them to shareholders via dividends and share buybacks.

That is the good news - and it is worth adding that betting against the US market would have been an expensive mistake throughout the nine-year bull market since 2009. The bad news is that there are also a number of reasons to be negative about US shares.

The first of these is valuation. As we have pointed out here many times in recent quarters, the US is the world’s most expensive major market. Indeed compared to the rest of the world, it has exceeded the peak it reached in the late 1990s. Whether you look at valuations as a multiple of earnings or assets or relative to the dividend income paid by US companies, the alarm bells are beginning to ring.

Secondly, the US economy is in the late stages of the cycle. This is a time when risks increase because companies become more relaxed about raising borrowings and animal spirits re-emerge. We are seeing a deterioration in the health of US balance sheets. Expect this to show up first in the high yield debt market as defaults increase and then to spill over into the stock market.

The third reason to be nervous about US equities is the Federal Reserve. Bull markets tend to be killed off by central banks and there is no doubt that the Fed is further into its tightening cycle and more determined to restore monetary normalisation. With US workers likely to regain some of their lost pricing power as unemployment falls to historically low levels, we should expect rates to rise steadily through 2018.

The final reason to be cautious is that the US is starting 2018 from a higher base than other markets. More Americans already own shares than elsewhere so there is less money on the side-lines. And the US market is close to a share of global market capitalisation at which it has peaked in the past.

So, we have a balanced view of the US equity market, but definitely at the negative end of neutral.

Valuations: rising steadily

Source: Thomson Reuters Datastream, as at 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 an investment.

Select 50 pick: if you still want some exposure to the US (which most portfolios will) then the Rathbone Global Opportunities Fund, with more than half of its assets in US shares, is a good way to achieve it.

UK

I have been negative on the UK equity market for some quarters now since the post-referendum honeymoon ended and investors focused on slowing growth, declining real earnings and Brexit uncertainty. While none of those factors has really changed that much, the underperformance of the London market means the bad news is much more in the price. We’re upgrading the UK to neutral.

To start with the negatives, the UK market’s dependence on commodities now looks less appealing, with oil having settled in a new trading range and demand for base metals limited by slowing growth in China.

Secondly, economic growth is slowing for a number of reasons. Consumer confidence is weak as the sterling-fuelled inflation rate remains stubbornly higher than average household earnings growth. Business investment is weak. Perhaps most importantly productivity is poor.

Thirdly, the political backdrop remains unhelpful. The next year or so of Brexit negotiations will be tough and they will highlight the deep-seated divisions between and within political parties.

All this is known, however, and arguably factored into share prices in the UK, which anyway are less driven by domestic factors than most major stock markets.

The first of the positives is the valuation of the UK stock market, which on a number of measures looks compelling. First, measured against earnings, the UK equity market stands on a price-earnings ratio of just 14.4 compared with 14.8 in Japan, 15.5 in Europe and 18.3 in the US. Against companies’ assets, the price to book value is less than half that in the US and as cheap or cheaper than in every other major market.

The area in which the UK looks most attractively-valued is income. The yield on the UK stock market is about 3.5%. That is twice the yield available in Japan and the US and significantly higher than in emerging markets and Europe. Only in emerging markets are valuations as attractive when compared with expected earnings growth.

Other positives include sterling, which looks more likely to depreciate a bit from its current level than to appreciate by a great deal. The exposure of British companies to faster-growing emerging markets looks like a positive. Sentiment looks as negative as it is likely to get.

Finally, the prospect of a softer Brexit, with an extended transition period in which nothing much changes and businesses have the time to adapt to any new relationship with Europe, is looking more likely.

So, while things will remain tough in Britain for the foreseeable future, it feels that more of the bad news is now in the price.

Inflation: well above target

Source: Thomson Reuters Datastream, as at 15.11.17

Past performance is not a reliable indicator of future returns.

Select 50 picks: With income and the UK market’s defensive qualities looking like the main positives at the moment, we like the look of the Fidelity Enhanced Income Fund, managed by Michael Clark, and Nick Train’s Lindsell Train UK Equity Fund.

 

Europe

Europe remains our preferred regional equity market for a long list of reasons. The first of these is the strength and sustainability of the economic recovery. The region still has a lot of catching up to do after losing significant ground during the sovereign debt crisis. Europe’s economy is only just bigger than it was before the financial crisis, whereas the US and UK economies are 15% and 10% bigger respectively.

Markets have also lagged so there is a second string to the catch-up story. The failure of markets to keep pace has resulted in European valuations being significantly lower than those in the US. For stock-pickers there are a few sectors which look even more undervalued than the market as a whole - these include mining, industrials, insurance and car-makers.

Valuations look particularly low in Europe when you consider that company profit margins in the region are much more exposed to a pick-up in activity because the higher fixed-costs caused by Europe’s less flexible labour markets mean profits rise more as sales improve.

A further positive factor for Europe is its exposure to the financial sector. This has been a serious headwind in the past as the balance sheets of banks have been under pressure. But in an environment of slowly rising interest rates and higher bond yields, the profitability of financials is likely to improve.

Next in the list of positives is the European Central Bank which has been very supportive under the leadership of Mario Draghi and will most likely continue to be so thanks to the ECB’s single mandate to manage European inflation. With no sign of prices in the region rising there is little imperative for the Bank to do anything other than continue to stimulate the economy.

Finally, the political situation in Europe looks much less of a concern than it did this time last year. Having seen off the far-right threat in Holland and France, the chance of a populist upsurge in Europe is much diminished, albeit there is unfinished business in Austria and an election to come in Italy.

The one shadow that hangs over European equities is a further strengthening of the Euro which would make European exports less competitive. While the long-term outlook for the Euro is probably still positive, it has run a long way already so in the shorter term the currency looks less of a headwind than it has.

Economic sentiment improving

Source: Thomson Reuters Datastream, 15.11.17, quarterly percentage changes

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 an investment.

Select 50 pick: In a low interest rate environment, equity income will continue to look attractive. We like the Invesco Perpetual European Equity Income Fund, managed by Stephanie Butcher.

Asia and Emerging Markets

Investors in emerging markets enjoyed 2017. Returns were spectacular and it would be too much to expect them to continue at that level in 2018 as well. The combination of reasonable global growth and a weaker dollar has been a positive one for emerging markets and may be worse on both fronts this year. That said, there are plenty of positives in this asset class with valuations undemanding and the long-term growth story still intact.

China is the big unknown, of course. It accounted for more than 40% of emerging market returns in 2017, largely thanks to the performance of its tech giants, Tencent and Alibaba. Valuations are no longer as cheap as they were. And the government is squeezing monetary policy.

Much more interesting is India, which still has a great deal going for it despite being one of the most popular destinations for emerging market investors. In particular, demographics continue to look compelling and India is way behind China in terms of urbanisation and the growth of its manufacturing base. India should benefit from technology, with internet penetration still a long way behind China’s. Some of the headwinds affecting India are also weakening; it is little exposed to China at a time when that country’s economy is slowing and the oil price should not rise much further from here, a big help to a major oil importer.

Outside Asia, it is, as usual, impossible to generalise. Russia remains dependent on the oil price. Brazil’s economy is improving but politics remains uncertain. Mexico is a play on US growth. Because of these variations, we would always suggest a well-diversified exposure to emerging markets that does not put too many eggs in one country or regional basket.

Emerging market exports: rising tide

Source: Thomson Reuters Datastream, 15.10.17, 12 month percentage changes (3 months moving average)

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. Investments in small and emerging markets can be more volatile than those in other overseas markets.

Select 50 pick: Nick Price, manager of the Fidelity Emerging Markets Fund, is almost permanently on the road finding investment opportunities around the emerging world. This is the way to get an edge in this under-researched area.

Japan

The combination of reasonable valuations and strong earnings growth continues to be the principal reason to stick with Japan. There are plenty of reasons to expect profits to keep rising in Japan. A key one is the diminishing drag of wages as better-paid older workers retire. The seniority system for determining salaries in Japan has lumbered companies with uncompetitive cost structures. Like many things in Japan’s slow-moving corporate world, that is beginning to change.

Other positives for Japan include fund flows, with Japanese pension schemes very heavily weighted to bonds and households to cash. The potential for at least some of that to move into equities as the market starts to move higher augurs well for the stock market.

It’s worth remembering, too, that the Japanese central bank will by the end of this year be the only one still expanding its balance sheet. Also, a positive for Japanese shares is the likely downward pressure on the yen from rising US bond yields. A falling currency is always good for the Tokyo market. Finally, Japan continues to have a lead in a number of industries of the future like manufacturing automation.

There are still negatives for Japanese investors. For one thing, Japan is no longer the great hidden secret of the global stock market. An overweight position in Tokyo is now more mainstream and so more priced-in than it was. Japan’s demographics remain unfavourable; the country has high debts; and the shadow of China and North Korea hangs over the region. All of that said, though, there is enough going for Japan to keep it on our buy list.

Japanese economy: fundamentals strong

Source: Thomson Reuters Datastream, Q4 2017

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.

Select 50 pick: All three Japanese funds on the Select 50 are good. We particularly like the Baillie Gifford Japanese Fund thanks to its attention to the automation story.

Important information: Please be aware that past performance is not a reliable indicator of what might happen in the future. The value of investments and the income from them can go down as well as up, so you may not get back what you invest. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment. Investments in small and emerging markets can be more volatile than those in other overseas markets. Reference to specific securities or funds should not be construed as a recommendation to buy or sell these securities or funds and is included for the purposes of illustration only. This information does not constitute investment advice and should not be used as the basis for any investment decision nor should it be treated as a recommendation for any investment. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. Fidelity Personal Investing does not give personal recommendations. If you are unsure about the suitability of an investment, you should speak to an authorised financial adviser.

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