Highlights:
· The election of French President Macron stifled a global trend toward nationalistic populism.
· Global equity markets provided another quarter of solid returns although it is clear that the global economy will need to rely less on easy money policies to generate economic growth in the future.
· A recovery story seems to be underway in Europe, although several familiar headwinds remain in place.
· Japan’s economy has grown for five consecutive quarters and could be poised for further growth on the heels of a trade agreement with the European Union.
· Domestic equity valuations are on the high side, but currently supported by strong underlying economic fundamentals and corporate earnings.
Commentary:
The May election of Emmanuel Macron as President of France over far-right rival Marine Le Pen removed a major market overhang and seemed to be the trigger for another solid quarter for the global equity markets. The election result allowed investors to remain focused on strong corporate earnings and strengthening global economic growth during the second quarter. Nevertheless, investors remain highly focused on global political issues and central bank actions and it is likely just a matter of time before volatility, which has been almost nonexistent in recent months, returns to more normal levels.
The election of Mr. Macron at least temporarily stemmed the populist tide that has swept across the Eurozone after nearly a decade of lost economic growth, terrorist attacks and a wave of migration. This has fueled the rise of nationalist candidates like Ms. Le Pen, who have been further emboldened by the British vote to leave the EU and the election of U.S. President Donald Trump. After lagging the U.S. economy for much of the last decade, the long-awaited economic recovery in Europe might finally be underway, if strong economic growth, manufacturing activity, unemployment and consumer confidence numbers are any indication. Investors seem to have taken notice of the combination of attractive valuations relative to U.S. equities, diminished political risk in light of the France election results, low interest rates and a pickup in global growth, with funds flowing at least temporarily back to Europe, and international markets in general. Familiar concerns such as inflexible labor market rules, an aging population, constraints on government spending and the still unknown impact of Brexit on European growth remain in place so it is yet to be seen if the recent rebound is sustainable. In addition, elections still loom in Italy and Germany and these results could have significant implications on the European, and indeed, the global equity markets.
Despite stronger growth, the European Central Bank (ECB) signaled during the quarter that the bank wasn’t quite ready to wind down its large monetary stimulus, citing underlying inflation that was still too weak to justify a change in policy at the current time. The ECB has indicated that when it is ready to shift away from its easy money policy, it will likely follow the path laid out by the U.S. Federal Reserve and do so gradually. Specifically, the ECB plans to phase out a €60 billion-a-month bond purchasing program, followed by increases to short-term interest rates, which have been negative since 2014.
Nevertheless, the world is slowly moving away from the easy money policies that have helped drive the current eight-year bull market and the peak quantitative easing is behind us. The U.S. Federal Reserve (Fed) raised its benchmark interest rate to a range of 1 percent to 1.25 percent at its June meeting and provided a description of its plans to start reducing its portfolio of more than $4 trillion in bonds later this year. The Fed has now raised rates by a full percentage point over the last two years. Just recently, Fed Chair Janet Yellen voiced concerns about the high level of asset prices, Bank of England’s Governor Mark Carney and Bank of Canada’s Governor Stephen Poloz both hinted at rate hikes, and even ECB President Mario Draghi suggested the ECB could be nearing the end of its bond buying program in the near future. The dilemma faced by these central bankers is timing of the withdrawal of monetary support. Typically, falling unemployment would justify higher interest rates to prevent economies and asset prices from overheating. However, in this case, central banks must consider still tepid inflation that is running well below historical averages and which justifies continued stimulus measures to ensure it doesn’t drift lower. As economic growth continues to improve, central bankers will be looking for signs of slack in their economies disappearing, which would raise the potential for inflation to pick up.
Central bank leaders are likely managing their policies to avoid a Japan-like situation, which has dealt with sluggish growth and deflation for the last several decades. After more than four years, Prime Minister Shinzo Abe’s Abenomics policy package of government spending and easy monetary policy is finally offering hope that Japan is back on a path of stable, albeit unspectacular, growth. Strong global demand, especially for technology goods, and an improvement in household spending, has helped GDP expand for five consecutive quarters. The improvement in household spending is especially encouraging given the Japanese inclination for saving over spending that largely contributed to the long-term deflationary cycle. Japan also just recently announced a broad agreement with the European Union that would lower barriers on virtually all goods traded between the two nations. The deal still needs further negotiation and approval before it can take effect, but sends a strong signal for global cooperation against a trend toward protectionist policies being advocated by the U.S.
Emerging market countries have been the benefactor of a constrained U.S. dollar, low global interest rates and sustained developed market growth over the last several quarters. Growth in the emerging markets is poised to remain robust, but systematic risk from China and the associated effects on commodity prices remains in place. On this front, Chinese policy-makers continue to manage growth and institute financial reforms as the country transitions from an industrial-based economy to a more consumer-oriented economy. The hope is that China’s high potential growth rate will allow the government sufficient policy tools to address any instability that arises during this transitory period.
With the global equity market rally now well in to its eighth year, it would not be unreasonable to conclude that we are in the midst of a market bubble. However, there is a significant difference between a market bubble and a market subject to potential correction. A bubble occurs when stock prices are going up but are not supported by proportionate growth in underlying fundamental earnings. An example of this was the dotcom bubble of the late 90’s, where many firms with no earnings reached extremely high prices on other considerations including potential revenue growth and market share. Conversely though, if equity prices are increasing because of good earnings and dividend growth in an economy which shows reasonable prospects for continued expansion, we would contend that’s not a bubble, but more a reflection of a favorable economic reality. This does not imply that equity prices may contract in such an environment, however, they likely should not crash.
The forward price-to-earnings (P/E) ratio of the S&P 500 was 17.5 as of June 30, 2017. This is higher than historical averages, but far below the 27.2 forward P/E ratio in March 2000 before the dotcom bubble burst. A correction of some fashion is more probable the longer this bull run persists, but if and when a correction does occur, consider that between 1965 and 2015 the S&P 500 underwent 27 corrections of 10% or more, but it ultimately recovered from each one. Equity market corrections and economic recessions are statisticaly quite common and may be considered even healthy in preventing bubbles. Nevertheless, the fundamentals for consumer spending, the largest contributor to domestic GDP, remain favorable. With incomes growing, inflation low, low interest rates and rising household wealth, it is not difficult to envision a scenario in which the U.S. economy continues to slowly, but steadily grow.
Likewise, the benefits of diversification have been called in to question recently, largely a result of the generally strong performance of U.S. equities during the recent bull market relative to international equities. However, we may be starting to see the beginnings of shift in this regard. It is inevitable with a diversified portfolio that at any point in time some investments will be outperforming while others will be underperforming. However, all equities in whatever market carry the anticipated return premium compared to less volatile cash and fixed income investments. Holding a broadly diversified array of such equities should mitigate the risk of just participating in a narrow area over time. It may be soon that international returns bolster weaker relative returns in the domestic markets.
As long-term investors who preach against market timing and advocate for diversification, we accept there will be all manners of local and global events which will have an impact on economies and markets. Although recently, there appears to be a relative calm in terms of market volatility, the number of potential global risks politically, economically, naturally, etc. can be beyond one’s imagination. However, an investment policy which concedes this level of uncertaintly by broadly and effectively diversifying holdings while taking a long term perspective should allow one to be indifferent to these events as they unfold while still offering the potential for meaningful returns.
Urban Financial Advisory Corporation - July 2017