A series of exceptional events led to wide swings in global equity performance from the first half to the second half of 2016. Looking into 2017, the Invesco International and Global Growth team is generally more constructive on non-U.S. stocks (versus U.S. stocks) from an earnings, quality and valuation (EQV) perspective, although we are keeping our eyes on three potential wild cards that could affect the outlook.
Looking back at 2016’s shift in sentiment
The year began with concerns over Chinese growth, which reinforced long-running fears of deflation and fostered a bias toward defensive stocks. But in mid-summer, the U.K.’s vote to leave the European Union, along with a recovering U.S. economy, pointed to a clearer path for the U.S. dollar. This marked an inflection point in terms of policy prescriptions to address weaker global growth — namely, politicians who wanted to keep their jobs began to embrace fiscal solutions rather than rely further on monetary solutions. This led to an abrupt shift in interest-rate expectations from negative to positive, and pushed market sentiment toward value over growth and cyclical stocks over defensive stocks. Notably, this all happened ahead of any meaningful change in actual earnings.
EQV expectations for 2017
Below is a high-level summary of how we view the global landscape in early 2017 via our EQV lens:
The outlook for global growth is improving. Many leading economic indicators edged higher through December after bottoming last spring during the height of Chinese growth concerns. For example, Citigroup’s G10 Economic Surprise Index hit 2010 levels in December, the eurozone manufacturing Purchasing Managers’ Index (PMI) hit six-year highs this week, and small business optimism in the U.S. has spiked to 10-year highs since the U.S. election.1
In addition, currency movements are slowly rebalancing growth toward international markets such as Europe and Asia ex-Japan. In these markets, we are seeing upgrades to 2017 earnings growth expectations, which are already double-digit. But in the U.S., 2017 earnings growth expectations are in the single digits, and revisions have been flat to downward. While some growth indicators have softened in in the past few weeks, the overall picture for earnings, particularly where weak currencies are rebalancing global growth, is improving.
We are more constructive on non-U.S. stocks versus U.S. stocks based on quality. Particularly, we see potential for non-U.S. corporations to see their returns on capital rise from currently depressed levels. In contrast, we see limited upside – or even potential downside – to U.S. businesses’ returns on capital. That’s due to pressure on their margins from higher wages as well as more-leveraged balance sheets after funding stock buybacks and dividend payments in the past few years.
Broad market equity valuations are no more compelling today than this time last year or even six months ago, in our view. This is due to the dramatic upward repricing of cyclical areas of the market ahead of meaningful improvement in earnings, coupled with only modest share price declines seen to-date in the more defensive growth stocks, as well as the possibility that higher growth/inflation could lead to higher bond yields and increased U.S. Federal Reserve (Fed) tightening versus expectations.
To summarize the EQV picture: Incremental returns to equity investors look to be much more dependent on the delivery of earnings growth, and that’s where we see greater scope for positive surprise outside the U.S.
Three wild cards to watch
I would add a few wild cards to this high-level outlook:
The U.S. dollar
The consensus view is that there will be incremental dollar strength in 2017 due to the Trump administration’s preference for more constructive fiscal and regulatory policies despite a firmer U.S. economic/wage backdrop. Should inflation expectations rise, the Fed could be forced to hike rates more aggressively than non-U.S. central banks, leading to further dollar strength.
There are two reasons why this consensus logic might be simplistic:
- Fed policy tightening will be informed by global conditions, not solely domestic U.S. conditions. Should non-U.S. growth indicators disappoint or global liquidity conditions deteriorate, for example, it is clear based on past actions that Janet Yellen’s Fed would consider this in setting U.S. rate policy
- Inflation is picking up given the strong year-over-year rise in energy prices, but this impact is set to fade from first-quarter data, and business pricing power remains limited given excess capacity in many end markets and budget-conscious U.S. consumers
To be clear, the path of least resistance for the dollar looks higher right now, but it is by no means a certainty, in our view.
Political event risk looms large over European/U.K. stocks during 2017, increasing the scope for higher volatility, but also for investment opportunities. In addition, it’s not yet clear whether President Donald Trump’s “America First” message should be seen as a negotiating tactic from which more constructive negotiations might emerge, or a more radical shift toward protectionist policies with less diplomacy. Regardless, President Trump’s unorthodox tactics will likely have both intended and unintended consequences for the global growth outlook, which increases the scope for volatility in the near-term, leading to potential opportunities for active stock pickers.
Emerging markets growth outlook
The outlook for emerging markets (EM) growth is uncertain. On one hand, further U.S. dollar strength and increased protectionism would be bad for dollar-based EM debt servicing costs and EM export growth. But on the other hand, earnings and return on equity are depressed in many EM markets, and continued global reflation could be constructive for both.
For example, China has been among the bigger beneficiaries of the recent shift from deflation to reflation, and growth indicators are improving. However, authorities must still walk a fine line balancing measures to arrest capital outflows without undermining still-imbalanced growth and inflation pressures. President Trump no doubt represents an unwelcome challenge to successfully negotiating this wire.
In summary, the EQV data we observe across the market lead us to be more constructive on non-U.S. stocks relative to U.S. stocks. However, selectivity is crucial as many cyclical areas of the market have bounced back despite a lack of earnings improvement, and more defensive/higher-quality areas like consumer staples have not yet reached levels where valuations are attractive.