Equity markets remain calm following the imposition of tariffs, as investors do not expect an escalation in trade tensions
Global equities entered Q3:18 on a positive note (MSCI World: +0.9% wow | -0.6% ytd), despite continuing trade tensions. Note that, as of July 6th, the US placed tariffs of 25% on Chinese imports worth $34 bn.
Corporate earnings announcements for Q2:18 and earnings guidance for future quarters will be key for equity performance going forward. The S&P 500 Q2:18 earnings season commences this week, with analyst expectations for EPS growth of 20.0% yoy in Q2:18 and of 22.3% yoy for FY:2018. Strong company results are expected worldwide for FY:2018 (MSCI World EPS growth: 15.6% yoy), albeit large gaps remain between the US and other regions (e.g. euro area 2018 EPS: +7.3% yoy | UK: +10.9% yoy).
US equities may also continue to find support in Q3:18 from elevated buybacks, with the latter likely gaining impetus following the large repatriation of profits held abroad by US companies during Q1:18 ($633 bn according to the Financial Accounts of the US). Recall that S&P 500 equity buybacks amounted to $181 bn in Q1:18, compared with a quarterly average of $131 bn in 2017.
Overall, the combination of weak returns in H1:18 and robust corporate profitability has brought down equity valuations compared with early 2018. Indeed, the US equities 12-month forward P/E ratio of 16.4x ranks in the 75th percentile since 2003 versus 18.6x and 100th percentile at the start of 2018. Japanese equities appear attractive, with the respective ratio of 15.0x ranking in the 16th percentile since 2003 versus 18.0x and 58th percentile at the start of 2018.
The euro area 12-month forward P/E ratio of 14.2x ranks in the 77th percentile since 2003, compared with 15.4x and 96th percentile at the start of 2018. The exporter-heavy DAX30 in Germany (Domestic Earnings: 22% - Other European: 30% - Rest of the World: 48%) has led the aforementioned correction, with a 12-month forward P/E ratio of 12.3x ranking in the 54th percentile since 2003 versus 13.8x and 95th percentile at the start of 2018.
Regarding sectors, Semiconductors and Telecommunications in the US, as well as the Autos sector in Europe, appear attractive (in valuation terms), following a significant price correction in H1:18, as they were at the center of international trade (and direct investment) disputes.
Regarding developments in government bonds, the flattening of yield curves is notable, with the 10/2 spread for US Treasuries narrowing by 19 bps in H1:18 and by a further 5 bps in the past week, to an 11-year low of 28 bps. However, in the minutes of the June Fed meeting, FOMC members downplayed the significance of such narrowing as a signal of heightened recession risks.
Indeed, “some” members noted that the slope of the yield curve in the current economic and financial juncture, could also be affected by: i) reduced estimates for the longer-run neutral real interest rate; ii) lower longer-term inflation expectations; and iii) relatively low term premiums. In the event, the reliability of the recent narrowing as a precursor of an ultimately inverted yield curve (which is historically linked to higher recession risk) could be reduced.