It has been morE than five months since president Trump’s surprise election victory infused new life into the eight-year long US equity bull market. Global markets have behaved as many, nticipated.The Trump administration’s recent failure to push through a proposed healthcare bill through the US Congress can thus be seen as the first speed bump. Investors are now questioning president Trump’s ability to make progress on the critical aspects.
Given this, is it time for investors to hit the pause button? Or, is there more to the reflation story?
We believe a US tax deal will be reached, but that this will take time, especially since the Republicans will be keen to ensure that there are, optically at least, revenue-boosting elements to any stimulus package that make any tax cuts budget-neutral over the longer run.
As it turns out, the reflation theme seems to be broadening beyond the US shores, with economic and corporate earnings growth estimates generally being revised higher, especially in Europe and Asia. Interestingly, the fiscal policy debate in Germany, which until now had led the Euro area’s move towards greater austerity, also seems to be shifting back in favour of more easing. We are also seeing signs of a revival in Asian imports and exports, while Russia and Brazil are emerging from a couple of years of recession. China’s policy-induced stability has clearly helped in this regard.
This bodes well for the medium term (6-12 month) outlook for equity markets. Thus, global equities remain our preferred asset class. Earnings growth expectations are robust and the pivot from economic ‘muddle-through’ to ‘reflation’ suggests this is unlikely to change dramatically. However, a gradual shift away from extremely loose monetary policy settings and, in some regions, elevated valuations suggest future equity market gains will be driven by earnings growth as opposed to price-to-earnings multiple-expansion, which is normal feature at this stage of a cycle.
Valuations in the Euro area are relatively low compared to the US, while 2017 earnings growth expectations have risen. Economic data is improving and the US dollar’s stability should be a positive as it means domestic policy settings can remain loose and Asia ex-Japan could benefit from a pick-up in FPIs. Within Asia, India and China remain our preferred markets.
Within bonds, there is a clear a preference for corporate bonds over government bonds and, particularly, for areas of the market that have less sensitivity to rising interest rates. This is because developed market government bond yields are likely to move gradually higher as the reflation story unfolds and the Fed gradually removes accommodation. Meanwhile, companies’ ability to service their debt is likely to improve under this environment.
Thus, our two preferred areas are US floating rate senior loans and developed market high yield bonds. Both sub-asset classes have significant credit risk but, because of this, offer higher yields and lower sensitivity to rising yields.
We are a little more cautious on Asian bonds though. Issuers from China and Hong Kong have become increasingly dominant players in the Asian dollar bond market. This exposes investors to higher concentration risks. Although China’s tightening capital controls and gradually rising interest rates have been successful in stemming outflows, any increase in concerns about China or reduced flows from Chinese investors could lead to sharp pullbacks in the market.
Of course, there are always risks of short-term weakness in equities and other riskier assets, especially at this time of the year, given seasonal tendencies and the upcoming elections in France. While we do not expect Eurosceptic parties assuming power and undermining the global, or even regional, economic outlook.
Also, some market indicators, such as implied volatility across different asset classes, do hint at investor complacency. However, fund manager surveys show there is still significant cash sitting on the sidelines which has yet to be deployed into markets. This is usually an indication of further equity market upside.
The author is chief investment strategist, Standard Chartered Private Bank