During November a brief mid-month wobble in equities was met with significant buying, which propelled most major indexes to all-time highs. The United States outpaced emerging and developed market international equities for the month. U.S. small- and mid-cap stocks led the way; value, led by the banks, modestly surpassed growth. U.S. high yield bonds posted modest losses as credit spreads widened with the fleeting equity weakness. Ten-year U.S. Treasurys gained modestly.
The main drivers of strong equity returns this year have been easier financial conditions, due largely to U.S. dollar weakness and broad earnings and sales growth. The 6.5% decline in the trade-weighted dollar has resulted from better than expected global economic growth, increased risk-taking, rising demand for non-U.S. equities and U.S. political dissonance. Will the dollar continue weakening? It’s not overvalued by long-term measures such as purchasing power parity, but the potential for larger budget deficits going forward may pressure the dollar further over the medium horizon. 3Q rounded out another solid quarter with sales growth of 5.5%, which beat expectations by the widest margin in over three years. Our expectations are for 10% earnings growth over the next 12 months.
The main fixed income theme has been flattening of the yield curve, measured as the difference between 10-year and 2-year Treasury yields. At the start of the year the difference was 120 basis points (bp), more recently the curve has flattened to 60 bp. When the yield curve goes to almost zero or inverts, generally it is a strong signal of imminent recession, with varying time lags. What has caused the flattening this year? The San Francisco Federal Reserve has issued a research note suggesting a lower normal interest rate, the risk of persistently low inflation and geopolitical uncertainty. We would add the enormous demand for higher yielding, high credit quality assets as another factor that has managed to anchor the 10-year note this year (Figure 1). In our view, the yield curve is one of many factors that bear monitoring for signs of a recession, and while it is flattening, it is not inverted.
As we reflect back on the very good year for equity markets globally (19.82% MSCI All Country World Index in U.S. dollars total return) it’s natural to ask, how much further can equities rise into 2018? Here we rest on our valuation, fundamental and sentiment investment process. In terms of valuation, MSCI All Country world is at 16.2x price/earnings multiple and the U.S. is at 18.3x earnings. Neither are what could be characterized as undervalued. On fundamentals, the consensus expectation of 10% global earnings growth looks achievable. The combination of above-trend global and U.S. economic growth and profit growth aided by corporate tax reform supports a positive outlook for equities. In terms of sentiment, the picture is a bit mixed: a handful of our measures are reflecting a degree of excessive optimism but the momentum and the strength of buying the dip even on most modest pullbacks tells us that the investment community is still keenly searching for returns (Figure 3) and repositioning away from downside protection.
We do expect a change in the equity and bond volatility profile over the course of 2018. It was relatively normal to have very low levels of volatility and modest pullbacks in equities over the past 18 months, as we had increasing momentum and breadth to economic and earnings growth. Going forward, while we still expect the data to be good, we may start to see a slowdown in its rate of change. We don’t think that is a game changer, however, the S&P 500 index has now had 265 days without a 3% pullback, which is a record based on historical data since 1930. Thus, it may be that equities grind higher for 2018, but the grind will be punctuated with one or two pullbacks of 5% or greater. We are watching the breadth of global markets with rising 200-day moving averages, which are hovering over 90%, still a positive picture. Global equity to global bond correlations are positive and have been for the past three years. We look there as well for signs of stress to equities – which would be bond yields climbing to a point where they pinch the outlook for corporate profits.
Our portfolio remains positioned for a positive global growth outlook. Our long held constructive view on the emerging markets remains, even in light of some relative weakness during late November. The emerging markets are still benefiting from a weak U.S. dollar and easy financial conditions. Likewise, we are maintaining our positive view on Japanese equities, which stumbled but recovered nicely in November. We see it as one of the markets with solid growth prospects, decent valuations and monetary policy that continues to be highly accommodative.
Multi-Asset Strategies and Solutions Team
Voya Investment Management’s Multi-Asset Strategies and Solutions (MASS) team manages the firm’s suite of multi-asset solutions designed to help investors achieve their long term objectives. The team consists of 25 investment professionals who have deep expertise in asset allocation, manager selection and research, quantitative research, portfolio implementation and actuarial sciences. Within MASS, the Asset Allocation team, led by Barbara Reinhard, is responsible for constructing strategic asset allocations based on its long-term views. The team also employs a tactical asset allocation approach, driven by market fundamentals, valuation and sentiment, which is designed to capture market anomalies and reduce portfolio risk.
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