The great shadow of the financial crisis may finally be lifting from the global economy. For two years now, every major region in the world has seen its GDP grow. The OECD reports all 45 of the economies it tracks are growing, with 33 enjoying accelerating growth.
It has been a long time since markets were perturbed by the global banking crisis, the troubles of the eurozone, a serious problem in emerging markets or a flare-up of the worries around China’s credit system. If equity markets sometimes look expensive, this economic background – as well as healthy earnings growth – offers reassurance.
Volatility has also remained very low
Are we detecting complacency or embracing the spirit of optimism? The full answer is nuanced, but the headline is that we are cautiously optimistic. We are favouring moderately higher risk, preferring equities over fixed income, while we are also positive on emerging markets. However, we are maintaining a sense of caution due to the low-volatility environment.
US equity valuations are elevated
While we prefer equities over fixed income, there are geographic distinctions. We are maintaining a ‘Below Normal’ outlook for US large caps and are reducing our outlook for US small and mid-caps to ‘Neutral’ from ‘Above Normal’. Growth stocks have outperformed Value in both large caps and small and mid-caps, as large caps with multinational operations have benefited from dollar weakness and cash repatriation.
Valuations are elevated, but not necessarily to the extent that they are a timing signal. Geopolitical risks, especially around North Korea, continue to cause concern, as does the potential for the major central banks to tighten liquidity conditions too early or too aggressively. On the upside, small and mid-cap companies and more cyclically-oriented stocks are most likely to benefit from any progress on tax legislation, as many large companies already pay less than the headline corporate rate.
Upgrading an improving Europe
Outside of the US, we have increased our outlook for non-US developed market equities from ‘Neutral’ to ‘Above Normal’. In Europe, economic recovery has seen unemployment rates drop rapidly, pushing the euro up strongly. The ECB remains accommodative for now, although it is beginning to contemplate how to wind down its QE programme.
Japanese equities tend to benefit from a weaker yen flowing through to corporate earnings, and the Bank of Japan remains committed to propelling the economy forward and its yield-targeting policy. If there were any signs of the current synchronised global growth breaking down and slowing, this would be seen first in Japan. The UK is undertaking its Brexit negotiations with the European Union, but market reactions seem to be isolated to the UK for the time being.
Higher EM growth still a tailwind
As for emerging market equities, we maintain our ‘Above Normal’ 12-month outlook. Emerging market economies and equities are likely to continue to benefit from synchronised global growth, with the relatively higher growth rate remaining attractive.
Among key risks are a potential financial shock from China, a slowdown in global growth and a return to dollar strength. Although, this latter risk is one many emerging economies are less vulnerable to today, having made substantial balance sheet adjustments over recent years.
Erik Knutzen, CIO of Multi-Asset Class Investments at Neuberger Berman