The high volatility of recent weeks likely represents a regime shift from the low volatility environment of 2017. Fortunately for equity investors, the US Federal Reserve has been overt in its communications about ‘normalizing’ policy. As a result, corporates have taken the opportunity both to lock in low interest rates and extend the term of their borrowings, providing a cushion against near-term refinancing risks as well as most immediate negative impacts to earnings from rising rates. We do not therefore expect earnings to be negatively affected by the changing landscape in the US bond market while select sectors should benefit from the rising rate environment.
However, the pivot in the volatility regime is likely to mean that expanding valuations which have served as a tailwind for equity returns in recent years will fade, forcing investors to rely on corporate earnings growth as the primary driver of returns. Indeed, since 2011, multiple expansion has accounted for almost half of the total returns generated by the S&P 500. In fact, even in challenging periods for the markets, such as 2015-16, multiple expansion served as the primary driver of returns while, with the return of earnings growth in 2017, multiple expansion still contributed nearly 7 percent of the 21 percent in the total returns generated by the S&P 500.
So, looking into 2018, rising volatility and rising interest rates should cap the contribution multiple expansion can make to investors’ total returns. However, with strong growth supported by recent tax reform, earnings growth of 15 percent should be sufficient to drive positive returns in US equities.
While multiples likewise seem historically rich in emerging markets, strong earnings growth driven by economic recovery in Latin America and Eastern Europe combined with ongoing strength in Asian earnings should provide a more attractive risk-reward dynamic for global equity investors.
Even as Japan sees more modest earnings growth of 9-10 percent, still historically low valuations provide an opportunity for not only earnings driven growth as seen in the US and Emerging Markets, but also the potential for a more sustained multiple expansion to support total returns for investors in 2018.
As investors have increasingly pivoted their focus, rightly to the economy and corporate earnings, the specter of trade wars and other geopolitical risks remains in the background and could move center-stage as we progress towards the mid-year. As such, equity investors should capitalize upon the rebound in volatility and seek to build capital protection into portfolios should these tail risk events transpire.
As for the US dollar, despite a persistent Fed and as of yet, more patient central bankers at the ECB and the Bank of Japan, the currency has weakened relentlessly since early-2017. However, it is worthwhile recognizing the starting point from the US dollar weakness which was its value being the most expensive in real effective exchange rate terms since the Plaza Accords devaluation of the US dollar in 1985.
While most (including ourselves) have focused on the widening interest rate differential between the US dollar and other key currencies around the world, 2017 saw a number of important inflections in key drivers which are now weighing upon the US dollar. Perhaps the most visible was the early-2017 surprise in European economic growth which left eurozone real GDP growth rates at a premium to US growth rates for the first time since 2011, near the start of the bull market in the US dollar.
Moreover, whereas during the 2011-16 bull market in the US dollar, underlying economic fundamentals tilted in favor of the greenback from 2017 onwards, those same fundamentals are now proving to be headwinds to US dollar strength.
The US budget deficit which had troughed at nearly 10 percent of GDP at the depths of the Global Financial Crisis in 2009 narrowed to 2 percent of GDP in 2015. While eurozone fiscal deficits widened to 6 percent of GDP during the crisis and narrowed again as recovery took hold, the single currency area only succeeded in closing its budget gap to a comparable 2 percent of GDP in 2015.
In 2017, the eurozone economic recovery and fiscal prudence allowed its budget deficit to narrow further to 1 percent of GDP. In contrast, the inability of US President Donald Trump to deliver fiscal restraint continued to push the US fiscal deficit out further to 3.4 percent by end-2017, even before the implementation of the tax reform plan passed in December. With the tax reform plan expected to expand the deficit to as much as 5-6 percent of GDP by 2019, a further headwind for the US dollar lies ahead. This was further compounded by the introduction of the Chinese yuan into the IMF Special Drawing Rights (SDR) basket and a shift from a managed US dollar-referenced rate to one managed against the broader SDR basket incrementally increasing the suitability of yuan investment for central banks in particular looking to diversify US dollar-heavy positions.
The potential to ‘price’ this deterioration in the US dollar has weakened and interest rates have begun to rise in the US leaving the differential between US dollar rates and German counterparts as nearing the widest seen since the late-1990s. Tactically, one-sided positioning against the US dollar combined with the wide interest rate differential suggest a reversal in the US dollar weakness of the past year may be in the offing supported by renewed political uncertainty in Europe (Italian elections/German coalition), a delay in the expected September start to ECB ‘tapering’ of its quantitative easing program, and/or a relapse in eurozone growth momentum relative to the US.
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