Last year marked a turning point for equities after a protracted period of quantitative easing (QE), low interest rates and risk-averse investing since the financial crisis.
Fears of deflation turned to hopes of reflation and bond yields bottomed, as investors started to look forward instead of assuming more of the same.
Bond yields began to rise as the expectations of higher interest rates and higher inflation – the so-called ‘reflation trade’ – grew. At the same time, there was a dramatic rotation from bonds to equities, quality to value and defensives to cyclicals. The more optimistic macro outlook led investors to reassess company valuations and refocus on fundamentals.
This year, however, the reflation trade has paused and risk appetite has generally declined as investors weigh the prospects for pro-growth policies against the effects of protectionism on global trade.
The cyclical rally has also retreated, with some defensive sectors and so-called ‘bond proxy’ stocks performing strongly once more. Yet overall, equities have proved resilient in face of uncertainty because of an improvement in economic growth, company fundamentals and earnings expectations.
While politics has undoubtedly played a defining role in determining investor sentiment this year, the key point is that the equity rally of the past 12 months been underpinned by improving global macro data and rising inflation expectations, with politics being an extra moving force on top.
As we progress through 2017, political risks are gradually receding, particularly in Europe where the recent election of Emmanuel Macron as president suggests momentum for the political far right across the region may be slowing. Global growth is stronger and more synchronised than it has been since the financial crisis, contributing to a generally supportive backdrop for risk assets. A crucial factor in the equities rally though, is a sustained recovery in earnings.
Most of the equity bull market prior to last year was driven by multiple expansions rather than earnings. Earnings growth is finally coming through now, predicated on a more stable economic environment. Global earnings
are being revised upward with,
for the first time since 2010, consensus earnings forecasts pointing to positive growth in all major global regions.
Earnings data for the first quarter from across the globe supports a synchronised recovery. In the US - in the best reporting season in 13 years - some 68% of companies have beaten on earnings per share (EPS) and 63% on sales, with EPS now tracking 12% year on year. Meanwhile in Europe, 63% of companies have beaten on EPS and 71% on sales, the best since 2003 (according to data from Bank of America Merrill Lynch research). Consensus earnings have now risen to 14.6% for Europe in 2017.
Global equities markets look set to benefit from this globally co-ordinated earnings recovery.
Additionally, correlations between stocks are reducing and should continue to do so, while the dispersion of returns increases. (Notably in the US, stock correlation on the S&P 500 has already declined to below the historical average.) Both of these trends are constructive for actively managed portfolios.
As the lengthy period of monetary easing comes to an end, many of the policy-driven trends that drove returns in recent years, such as the decline in bond yields, the rise in equity valuations, and the compression of credit spreads, are now close to exhaustion. This suggests an environment of lower and more variable returns than in recent years.
Against this backdrop, asset allocation and an active stock selection approach will be key, as future outperformance will need to come from relative earnings gains and from stock selection within sectors.
Ritu Vohora, investment director, M&G Investments
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