Taking Stock of Trends, Opportunities, and Risks
At first glance, the current environment remains rather favorable for equity investors. Profitability is strong and continues to rise around the world, interest rates are still very low in most countries and valuations don’t yet look excessive, for the most part. But after an exceptionally positive 2017 and a rip-roaring start to 2018, investors have become more nervous, fearing that a breakdown in international trade relations or a monetary policy mistake could bring this economic cycle to an end. Volatility has returned to markets, with investors more inclined to punish perceived disappointments rather than celebrate successes.
- World stock markets have paused and volatility has returned, precipitated by concerns that trade tensions, and/or a monetary policy mistake, could bring this economic cycle to an end.
- We recognize the risks, yet see enough support from rising profits and sensible valuations to stay invested in stocks—and note that volatility is still moderate by long-term standards.
- Emerging market equities remain a favorite and Europe is more appealing after recent underperformance.
- Financial stocks worldwide offer plenty of opportunity and the high-flying technology sector, while clearly less attractive now, is not yet a threat to investors.
While the upswing in global corporate profits that began in mid-2016 continues, market participants understand this trend well, making positive surprises much harder to generate. Current expectations now reflect the boost to U.S. earnings from lower corporate tax rates, although the expected buybacks, dividend increases and additional spending as a consequence of the tax windfall have yet to be fully revealed. Profits across a range of emerging market economies are moving steadily higher, even though positive surprises are less frequent now.
Opportunities - Regions
We continue to believe emerging markets will offer the best returns in the next couple of years. So far, the upswing in emerging markets profits is less mature compared to the U.S.; market valuations are reasonable on all the measures we analyze; and the interesting, longer-term secular case for many of these markets is not really priced in.
Opportunities - Sectors
Financial stocks continue to merit a high weighting in many of our equity strategies. The sector, which languished after the global financial crisis, has partially returned to favor in the last couple of years, but valuations are still sensible. Profitability is improving at a healthy clip, helped by better economic conditions and the recent rise in U.S. interest rates. And with tougher capital standards largely met, profits are flowing back to shareholders in stock repurchases and higher dividends. Investors must, however, remember the risks in the financial sector, which is still highly levered (though less so than going into the 2008 financial crisis) and often opaque.
After last year’s extraordinary combination of strong returns and low volatility, equity markets were bound to get more difficult. That has indeed come to pass. The proximate causes, trade wars and tighter monetary policy, may have cast doubts on the economic cycle’s longevity. Still, we think there is enough profit growth ahead to stay fully invested in equities, even while we recognize that the balance of risk and reward is now less compelling. Emerging markets and Europe are worth attention and the financial sector is still relatively attractive.
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