In the aftermath of a tumultuous 2016, much discussion has centred around the equity outlook for 2017 and beyond. In fact, the second quarter saw continued strong performance from global markets, though in our view, the long-term earnings outlook remains murky. As we enter the second half of the year, Invesco’s International and Global Growth team assesses global equity performance to date through our EQV (earnings, quality and valuation) lens to identify the key areas to watch – along with potential growth opportunities.
Strong global performance with a focus on growth over value
Similar to the first quarter, the second quarter saw strong global market performance, with the total return for the MSCI AC World Index up almost 12% through the end of June. Emerging-market equities have been the primary winners year-to-date, with the MSCI Emerging Markets Index up nearly 19%, followed closely by the MSCI Europe Index (up nearly 16%), and the MSCI Japan Index and the S&P 500 Index, both up just shy of 10% in U.S.-dollar terms).1 (All data is in U.S.-dollar terms.)
From a style perspective, growth outperformed both the broad market and value in the second quarter, just as we saw in the first quarter. Over the second quarter, the MSCI AC World ex US Growth Index was up 7.6% versus the index’s value benchmark, the MSCI AC World ex US Value Index, which was up 4.1%. Meanwhile, the MSCI AC World ex US Index was up 5.8% for the quarter.1 (All data is in U.S.-dollar terms.)
Mixed signals for earnings growth
Most leading economic data began the second quarter much like the first quarter ended – on a firming trend, particularly outside the U.S. However, declining inflation expectations driven mainly by lower oil prices, a marked reversal in the chorus of positive U.S. economic surprise data seen in the second half of 2016 and a clear shift in federal rate policy, led to a fairly steady decline in U.S. Treasury yields and a pause in the global yield-curve steepening that began a year ago. We’ve also seen a pause in the upward profit revisions during the past month.
As a result, the second quarter saw investor appetite begin to shift away from the pro-cyclical/value-oriented areas of the market (including the financials, industrials and commodity sectors) that rallied off lows last summer in favour of defensive/stable growth stocks in health care, consumer staples and utilities.
While technology stocks have dominated performance indices in most regions, it is notable that year-to-date, the second-best performing sector in the MSCI AC World Index is health care. This is perhaps not surprising given lower bond yields and a more hawkish tone emanating from key central bankers of late. Time will tell if this represents the beginning of a more balanced growth market that would likely favour our EQV approach.
Despite the mixed data seen in the second quarter, we believe three key indicators continue to support the prospects for steady earnings growth through the second half of the year (which is critical to support the stretched absolute stock valuations that exist in many markets):
- Global Purchasing Managers’ Index data remain constructive.
- Monetary policy remains accommodative and financial conditions loose around the world. 3. Weaker oil prices (while they last) are stimulative for the consumer and may reduce non-wage inflation expectations (which could limit the scope for higher bond yields and discount rates).
Second-quarter EQV evaluations
Let’s take a high-level look at the second-quarter global landscape from an EQV framework:
During the past month or so, we’ve observed some moderation in the positive revenue and earnings revisions across virtually every region, compared to the steady stream of upgrades we saw in the first quarter. Notwithstanding this recent pause, global earnings momentum remains close to five-year highs, and the path of least resistance still appears up for most leading economic indicators and earnings outside the U.S. (particularly in the eurozone and Japan). Conversely, revenue and earnings revisions remained in negative territory in the U.S. (even if only modestly).2
The consensus expects earnings for the MSCI AC World Index to grow 15% in 2017. As of the end of June, this breaks down to 20% earnings growth expectations for the MSCI Emerging Markets Index, 19% for the MSCI Europe Index and 14% for the MSCI Japan Index, versus a more modest 10% for the S&P 500 Index.1
It is worth highlighting the runway for earnings recovery in the eurozone versus the U.S. Forward U.S. earnings estimates are now 30% above their last cyclical peak, while eurozone earnings remain 26% below their prior peak with better incremental operating leverage to higher revenue growth.1
In short, the data continue to suggest better earnings potential in the near term for non-U.S. versus U.S. equities.
Non-U.S. corporate balance sheet leverage does not appear excessive relative to operating cash flows and improving revenue growth. The U.S.-dollar weakness since the start of the year has helped ease costs for emerging market companies that are paying down debt in U.S. dollars.
Returns on equity remain depressed outside the U.S., with returns only lower on three occasions in the past 35 years.2 Similar to the potential evident in non-U.S. earnings versus previous peaks, the probability of higher incremental returns on equity for international investors remains strong in our view, particularly for Europe and Japan.
Despite improving revenue and earnings expectations, absolute valuations remain stretched. Cyclically adjusted price-to-earnings multiples have re-rated even further during the past three months in every major region except Latin America and Canada. Many stock market indices ended June at or near 12-month relative highs, thus requiring support from bond yields to remain low and earnings recovery to be delivered.
The same relative argument for non-U.S. equities versus U.S. equities that prevailed for the past decade persists today. In our view, however, what appears unique at this time, is the better apparent earnings potential for non-U.S. companies. Investors appear to have recognized the addition of better relative earnings growth potential today alongside this long-standing value argument for international equities, given the outperformance of international equities year-to-date.3 For U.S. investors exposed to this theme, the tailwind of stronger foreign currencies versus the dollar since the start of the year has further boosted dollar-based returns.4
Though the market’s willingness to look past valuation highs has persisted for some time, history suggests fundamentals will ultimately prevail. With absolute valuations elevated, we believe the investor who is most conscious of price paid will be better-positioned.
Our International and Global EQV strategies are thusly aligned, seeking to identify the best bottom-up, high-quality growth stock opportunities that offer the greatest risk-adjusted potential for non-U.S. equity investors.