Global equity markets recorded their twelfth consecutive month of gains in October as the cyclical upswing in global growth continues to be the dominant driver of returns across asset classes. The MSCI AllCountry World Index rose 2.1% on the back of stronger activity data and robust earnings growth across geographies and is up 20.6% yearto-date. The gains across risk assets came despite a range of political risks including a call for independence in the Spanish province of Catalan, China’s 19th Community Party Congress, snap elections in Japan and uncertainty surrounding the replacement of U.S. Federal Reserve Chair Janet Yellen. Undoubtedly, the continued expansion of global central bank balance sheets has helped drive valuations on financial assets higher and cushioned the market against volatility. Yet what has distinguished 2017 is this period of accommodative financial conditions is occurring against a backdrop of synchronized global growth, the strongest since the global financial crisis, and which we believe will continue to support risk assets into year end.
The combination of steady growth, low rates and suppressed volatility—a “goldilocks” scenario—has been a defining characteristic of financial markets this year. The growth dynamic has been especially pronounced; according to the Organization for Economic Cooperation and Development (OECD), all of the forty-five economies it tracks are expanding, the first time in a decade that this has been the case.
The International Monetary Fund (IMF) confirmed this strength in its most recent outlook from October 2017, in which it estimated global growth at 3.6% this year and 3.7% in 2018. High-frequency indicators, including the J.P. Morgan Global Manufacturing PMI which is at a multi-year high, showed this momentum continued in October.
This dynamic has translated into stronger earnings growth across geographies. According to J.P. Morgan, 2017 is on course to be the first year since 2011 where the majority of the gains in U.S. equities will come from earnings growth as opposed to multiples expansion. A similar situation is occurring for European equities where earnings growth is expected to be 11% year-on-year. We have passed the busiest period of earnings announcements for the third quarter and results have been strong. In the U.S, where 43% of companies have reported, 79% of S&P 500 companies beat earnings estimates, the best in three years. In Europe, where more than 40% of companies have reported, 53% of companies have beaten estimates while Japanese firms are showing more than 10% earnings growth.
Though policy risk still remains high, especially in the U.S. with regards to tax policy and fiscal expansion, inflation expectations, which have been positively correlated with equity markets, are moving higher. This has partially been driven by the energy complex as Brent crude oil gained 8.25% in October and traded above $60 per barrel for the first time since July 2015. In the U.S., 5-year breakeven rates which gauge inflation expectations stand at 1.8%, up from 1.6% in June. Meanwhile, in Europe, 5-year swaps show inflation is also expected at 1.8%, up from 1.7% over the summer. While these readings do not indicate rapidly growing inflation expectations, they indicate a shift in the trend as both the Federal Reserve and European Central Bank have indicated that softer inflation readings were somewhat temporary and are likely to recover over the medium-term.
In terms of our asset allocation, we continue to prefer equities over fixed income and credit over government bonds given the global growth theme amid slowly rising inflation. On the equity side, our asset allocation remains relatively unchanged with a preference for Europe and Japan over the U.S. given relative valuations, economic momentum and monetary policy cycles. Our allocation to Japanese equities on a currency hedged basis drove our equity market returns over the month given the 8.9% gain in the Nikkei 225 as the party of Prime Minister Shinzo Abe secured a supermajority in snap elections providing a boost to “Abenomics” and strengthened our conviction that the country’s expansionary fiscal and monetary policy will continue. Within emerging markets, we continue to be overweight China and emerging market Asia which are up 51% and 39% year-to-date given easy financial conditions, stronger trade activity and external demand.
In credit markets, spreads on U.S. high-yield and investment grade bonds put in new lows on the year to be up 7.5% and 5.9% respectively according to Bank of America-Merrill Lynch (BoAML) Indices. Spreads within U.S. high-yield remain just 26 basis points above their cycle lows registered in 2014.
While we continue to be constructive on the asset class given default rates that remain around 2%, we recognize that at current valuations, the returns going forward will be driven more by coupon than capital gains. This stands in slight contrast to European highyield, where we have trimmed our allocation in favour of the U.S. At yields of just 2.12%, below the yield on the 10-year U.S. Treasury bond at around 2.35%, we do not believe investors are being adequately compensated for the credit risk. At the same time, we believe that European credit markets are more sensitive to the withdrawal of monetary stimulus than those in the U.S. given the extent to which corporate bong buying by the European Central Bank has distorted credit markets. The European Central Bank has already indicated it is going to taper its current bond buying program to 30 billion euros per month from 60 billion, starting in January 2018.
While we expect risk assets to be broadly supported into year-end, we recognize the withdrawal of central bank liquidity, whether by the Federal Reserve through the normalization of its balance sheet or the tapering of assets purchased by the European Central Bank, could pose a challenge to markets sometime in 2018. At the same time, a high-degree of policy uncertainty remains in the U.S. over corporate tax reform and other forms of fiscal legislation. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.