DAVID LAFFERTY, CFA®
Senior Vice President and Chief Market Strategist
Natixis Global Asset Management — U.S. Distribution
As we move into the second half of 2017, there may be a sneaking suspicion among investors that something is askew. While the market news flow is heavy, the markets themselves are eerily quiet. Realized and implied volatilities across global stocks, bonds, and currencies are near all-time lows. Global stocks continue to move higher, but it is likely that few investors believe in this rally wholeheartedly. Adding to the confusion is the modest rally we’ve seen in global bonds, with yields falling from their March 2017 peak. Should stocks (risk assets) and high-quality bonds (widely considered to be relatively lower-risk assets than stocks) be rising at the same time? And which market is foreshadowing the true outlook for the global economy? Maybe both. We believe the investment environment today is characterized by two countervailing forces: improving fundamentals offset by relatively high valuations. This combination of forces may be prompting both investor apathy and low market volatility.
Seen through a wider lens, the fundamental side of the global economy appears to be picking up steam. As the chart below shows, activity metrics such as the Purchasing Managers Indexes (PMIs)1 – an indicator of the economic health of the manufacturing sector – are now experiencing a synchronized expansion across the U.S., Europe, and emerging markets for the first time in years.
In the United States, Gross Domestic Product (GDP)2 is expected to grow at close to 3.0% in Q2 and just over 2% for the full years of 2017–18. (None of this is predicated on President Trump’s pro-growth policies, which we view as largely stalled for now.) Likewise, Europe is awakening from its slumber. Real GDP is approaching 2%, unemployment is falling, credit demand is rising, and the fear of deflation looks to be waning. Emerging markets are gaining traction with investors, paced by China, where the growth rate has stabilized in the last year, and India, which is rebounding seemingly well from demonetization. Consistent with stronger global growth, corporate earnings estimates are rising, creating increased fundamental support under risk assets like stocks and corporate bonds – hardly a backdrop likely to lead investors to be bearish moving into the second half of the year.
However, market data through June 30th may reflect greater skepticism. Global equities continue to grind higher and credit spreads3 are holding steady, but bonds are rallying and most yield curves4 are flattening. In addition, commodity prices – considered a bellwether for economic demand – continue to struggle. These signals might foreshadow lower growth and inflation.
As a result, investors are left with a murky picture, caught between the positive macro signals coming from equities and corporate bonds and the warning signs emanating from interest rate and commodity markets. For now, we believe improving economic fundamentals will carry the day. However, we’re paying close attention to better determine whether the recent market signals are just short-term noise or a true harbinger of a slowdown.
Not to be forgotten within this economic environment, we find asset valuation5 to be far from compelling. No broad asset classes that we can identify are “pound the table” cheap. Depending on which central banks you want to include, global quantitative easing (QE) programs have added between $14 and $18 trillion in assets to the banking and financial system. This has likely resulted in high equity valuations globally, while both interest rates and credit spreads remain relatively low across the bond market. As a result, asset prices seem to be compressed into a trading range, supported from below by improving fundamentals but limited in their upside by stretched valuations. This may be what has led to generally declining levels of volatility across most asset classes since mid-2016.
Caught between improving fundamentals and constraining valuations, the global equity markets may continue to offer investors positive returns in the second half of 2017 and into 2018. However, we think this return will be predicated on “clipping the coupon” (an expression usually reserved for bonds) of earnings growth, not a broad expansion of price-to-earnings (P/E)6 levels. Based on slightly better relative valuation and less “Trump risk,” our modest preference for European and emerging markets remains in place.
In bonds, we believe the massive dislocation between negative interest rates (expensive high-quality bonds) and wide credit spreads (cheap corporate bonds) in early/mid 2016 has largely been eliminated. With yields quite low, we believe any additional yield from the corporate sectors of the bond markets is still relatively attractive. However, prudence should still prevail as we get later in the credit cycle. If global growth unfolds as we expect, there should be modest upside pressure on yields. Absent a recession, high-quality bond returns should be similar to their yields, at best.
Periods of abnormally low volatility cannot persist forever. While we see little evidence of systemic risks in the global economy, we believe the remainder of 2017 could offer some negative surprises or increased volatility. These could include a Trump tax reform disappointment, a U.S. debt-ceiling debacle, new evidence of slowing growth in China, or geopolitical missteps in the Middle East or North Korea. However, assuming these potential setbacks don’t undermine the upward trend in economic activity, they may provide a chance to rebalance into better valuations. In the meantime, some investors may elect to participate in a gradually improving economy without being overly aggressive, as current valuations may not warrant it.
1 The Purchasing Managers’ Indexes (PMIs) is based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment.
2 Gross Domestic Product (GDP) is the total value of goods produced and services provided in a country during one year.
3 The term credit spreads refers to the difference in yield between two bonds of similar maturity but different credit quality.
4 The term yield curve refers to a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
5 Asset valuation is the process of assessing the value of a company, real property, or any other asset capable of producing cash flows.
6 The price-earnings ratio (P/E) (sometimes referred to as the price multiple or earnings multiple) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
Equity Stocks are volatile and can decline significantly in response to broad market and economic conditions.
Fixed-income Bonds may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Emerging markets refers to financial markets of developing countries that are usually small and have short operating histories. Emerging market securities may be subject to greater political, economic, environmental, credit and information risks than U.S. or other developed market securities.
Diversification does not guarantee a profit or protect against a loss.
All investing involves risk, including the risk of loss.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.