Trade tensions, central bank policies and corporate profitability will shape the investment outlook in Q3:2018
Global equities were flat on a weekly basis (MSCI World: +0.1% wow | +0.6% ytd), as robust corporate earnings and positive economic data were offset by trade-related uncertainty. Year-to-date, US equities have over-performed, particularly since early April due to stronger fundamentals (see graph below).
Emerging market equities continued to lag their developed peers (-0.5% vs +0.2% wow in $ terms). Mounting trade tensions that, if escalated, could result in slower global trade and growth, have weighed on the EM performance (-7.6% year-to-date vs +1.7% for DM) on top of a stronger USD (negative for EM assets).
In contrast, (i) attractive valuations, with the MSCI EM 12-mth Forward PE at 11.3x vs a 15-year average of 11x (reflecting a 27% discount relative to MSCI DM PE vs a 15-year average discount of 23%), and (ii) favorable positioning from a contrarian view (as investors appear neutral to underweight) could support EM assets if trade concerns do not lead to a full-blown trade war or if Fed policy turns dovish.
Regarding the rest of 2018, global growth is expected to continue at a firm pace, with US GDP growth expected at a solid 4% qoq saar in Q2:2018 (due on July 27th). Corporate profitability also remains healthy, with expected MSCI AC World EPS growth of 15.6% yoy in 2018 from 17.1% yoy in 2017 (see page 3).
Moreover, consensus expectations for euro area and Japanese EPS growth appear conservative (7% yoy and 3% yoy, respectively) in light of the recent stabilization in economic data and FX depreciation. Note that euro area manufacturing PMIs for July (55.1) stabilized following sharp declines between December (60.5) and June (54.9), albeit the services sector (54.4) came out below expectations.
On the other hand, however, higher tariffs on US imports and retaliation from major partners, if escalated from the current relatively low levels, could hurt corporate profitability through lower exports and higher input costs, thus undermining investor confidence. According to our estimates, tariffs of c. $158bn or 0.9% of world exports have been implemented, so far, with $559bn in the pipeline (3.3% of world exports).
Quantitative tightening is also a cause for concern. Note that combined net asset purchases by the Fed (-$423bn in 2019), Bank of Japan (+$282bn in 2019) and ECB ($0bn in 2019) are expected to turn negative in 2019 (see graph below). No change regarding interest rates and QE (which ends in January 2019) is expected at the ECB meeting on July 26th.
As a result, we have adapted our equities’ allocation to benchmark (Neutral), maintaining our overweight position in cash, as a hedge, as well as a way of being tactical (see Asset Allocation page 4). USD cash appears attractive, with the 3-month UST bill yielding 1.97% and surpassing the S&P500’s dividend yield (1.91%) for the first time since 2008. Government bond values are expected to continue to decline due to better growth, expansionary fiscal policies and less central bank support, albeit the 10-Yr US Treasury yield at 3% appears to trigger strong demand from investors.