2016 ended with risk markets riding high, driven by improving economic data and excitement that the incoming Trump administration could allow one of history’s longest bull markets to endure a little longer. We do agree that, in aggregate, the policies President-elect Trump and the encouraging team that he is assembling around him are likely to bring about a better environment for businesses to operate in, supporting GDP growth through infrastructure spending and encouraging private sector investment – something that has been underwhelming during the current business cycle upswing. Despite the negative feeling towards the new presidency, risk markets have responded positively to the promise of sustainable business-led growth. Lower taxes, a more effective government (due to the Republicans having control of both the White House and Congress), and the opportunity for businesses to repatriate offshore profits without incurring large tax bills are all positive drivers. Economic growth in the US should ultimately give rise to growth in other markets, although a shift away from ‘free trade’ is a worry given that 60% of the world’s GDP relies on trade.
Elsewhere, Europe and Japan are both still operating under aggressive monetary policy and showing an improvement in both their inflation and growth. Domestically, the UK continues to do better than expected following the EU referendum, but we still know very little more than we did at the time of the vote. Ultimately, the effect is still uncertain. Our view is that the negotiations will result in a compromise of some sort with the UK retaining most of its access to the single market, while making some concessions on the free movement of people.
Our principal concern for equities as an asset class remains the risk that as companies report earnings they fail to deliver the growth expected by the market. The strong dollar and higher interest rates are headwinds for companies to overcome, although better earnings from companies in the financial, energy and basic material sectors should offset this. Longer term forecasts remain optimistic and are likely to be revised downward should global growth remain at the current soft levels.
An investor can build an argument based on price to support either a bearish or a bullish investment case. Relative to its own history most equity valuation measures such as free cash flow yields and price-to-earnings ratios indicate that the asset class is trading ahead of its long term trends – highlighting downside risks. Following the 3rd Quarter earnings season a likely outcome for the S+P 500 earnings will be around the $118 level, which puts the earnings multiple at 19 times. When viewed relative to core government bonds the risk premium shows that equities as an asset class are not expensive, although this discount has narrowed in the fourth quarter.
Financial markets are focussed on central bank policy and the possible pro-growth policies that the incoming Trump administration could deliver. There is a belief that central bankers will ensure that global economic activity does not slip back into recession and that this will continue to drive asset prices. Recent increases in inflation expectations support the prospect of higher interest rates, but we feel that much caution will be used in the tightening process and that central banks may be prepared to look beyond transitory inflation impulses caused by currency and commodity fluctuations.
|Figure 1. Five year breakeven spreads for the UK and US|
Ultimately, equity performance is a function of rating change and earnings growth. Given current valuation levels and the tightening direction of monetary policy it is hard to see a rerating overall in the broader equity space. Earnings growth is made more difficult by the strong dollar, low economic growth, the high base of profit margins and declining labour productivity.