Tuesday, August 22, 2017
The Positive Case for Global Stock Markets
At the beginning of this year, we forecasted advances in both the US and international stock markets. Our view was that the US market would be driven by a surge in corporate earnings, whereas international markets would benefit from accelerating global economic growth, low inflation, and accommodative central banks. Markets have indeed responded: the iShares MSCI ACWI World ex US ETF has risen 16.8% and the S&P 500 Index has risen 9.5% year-to-date.
Investors are asking if the recent stock market advances are justified and are concerned that further gains will be difficult to achieve. Fueling the negativity has been a flood of media coverage focused on market observers who forecast a correction. Skeptics point out that the market’s valuation is above its long-term average, that considerable time has passed since the last market sell-off, and that a “black swan” event could cause short-term weakness. However, there are equally strong reasons to remain positive on equities:
- The expectation for global and US economic growth continues to strengthen into next year. The International Monetary Fund increased its global growth forecast in its April update from 3.4% to 3.5% in 2017 and expected a rise of 3.6% in 2018. The IMF noted strength in Japan, Europe, and China. The pickup in commodity prices has lifted emerging economies and relieved some deflationary pressures in developed economies. Deutsche Bank Research, in its column, “The House View” (July 25), pointed out that this is “the most robust global growth backdrop that we have had in years … with new signs of a broad-based, synchronized growth uptick.” The US economy remains solid and could achieve growth of over 3% in 2018. In our view, potential tax reform and infrastructure policies are not currently priced into the market, and legislation might support further advances in the market.
- Global central banks remain accommodative. Even though the Federal Reserve raised rates twice this year and will likely begin its balance sheet reduction next month, we expect their tightening path to be gradual now that recent US inflation data has come in below expectations and below the Fed’s 2% target. Similarly, inflation in the euro zone and Japan remains below central bank targets of 2%.
- S&P 500 earnings have been strong and could continue to surprise to the upside. Second quarter earnings reports have been very positive: over 90% of S&P 500 companies have reported on average 10.2% earnings growth, which was much better than the 6.4% expectation (source: FactSet). This double-digit trend is expected to continue into the second half of 2017 and provide a boost to the US stock market. In addition, the US dollar has declined over 8% this year, and a further decline will lift corporate profits later this year.
- International market valuations are attractive and the US market valuation is above average but not excessive. International markets have not only outperformed the US market year-to-date, but they are also less expensive than US stocks. The MSCI EAFE Index for developed markets is up 17.5% this year through July 31 and yet has a forward P/E ratio of 14.8. Similarly, the MSCI Emerging Markets Index increased 25.8% through July 31 and has a forward P/E ratio of only 12.5. While it’s true that US markets trade above long term average valuations, current levels do not necessarily portend a coming sell-off. It is just as conceivable that valuations remain steady and stock prices rise along with the surprisingly strong corporate profit growth. We also believe that elevated valuations are justified because investors have a greater appetite for stocks given the lack of appeal of alternative investment classes.
- There are few attractive alternatives to equities right now. Money market funds are yielding close to zero and the 10-year treasury yield, currently at 2.21%, is actually lower now than at the beginning of the year.
There is always a possibility of a correction in global stock markets. We think that such a pullback would be temporary, and barring a fundamental deterioration in global growth expectations, would view it as a buying opportunity. The biggest threat we see is the potential for protectionism and trade wars, but we think policymakers will avoid actions that would damage economic prospects.