It’s been a really good year for equities so far. Paradoxically, this is sowing the seeds of anxiety. Valuations are higher, so people are worried about a correction. Subdued volatility has stoked fears of renewed turbulence.
Stock returns have been solid across many regions. Japanese and emerging-market (EM) stocks led the second-quarter gains, while US large-caps also did well (Display, left). Smaller-cap US stocks underperformed as hopes for a broad tax cut that would benefit smaller companies faded. The MSCI World Index rose by 2.7% in the second quarter in local-currency terms to finish the first half up 8.3%, even after market moves during the last trading week of June signaled a potential shift in investor sentiment.
Growth and Stability
Let’s dig a bit deeper into this year’s shifting market trends. Growth stocks surged in the first six months of 2017, while value stocks underperformed—a sharp reversal of last year’s trading patterns (Display, right). Cyclical and defensive stocks posted strong returns, while resources trailed the market in another turnaround from 2016.
We think there are three explanations for these trading patterns. First, after last year’s US election, the market was driven by hopes that President Trump’s administration would unveil a series of policies to stimulate the US economy. These expectations fueled an increase of interest rates from historic lows, which buoyed value stocks, whose recovery prospects are helped by reflation and a cyclical rebound. This year, as political turmoil dampened hopes of major fiscal stimulus, interest rates have stalled, and as a result, cheaper and riskier stocks have underperformed.
Second, as anticipation of a US-driven growth burst have receded, investors have preferred stocks that look capable of delivering strong and steady long-term earnings growth in any economic environment. For example, companies like Amazon.com and Google are seen as big beneficiaries of long-term transformational changes in retail and technology. Beyond the US technology sector, some growth-oriented companies should do well amid relatively solid global economic growth conditions.
Third, oil prices have affected equity market trends. After rising through 2016 to about $55 a barrel, prices of US crude oil (WTI) have fallen by 18% this year to end the quarter at $46 a barrel. The slump in energy stocks has also hit value indices, which are heavily exposed to the sector.
Global Growth Continues
There’s plenty of good news underpinning these trends. Global economic growth continues to proceed at a steady, moderate pace. Inflation is generally subdued, so developed-market central banks will probably withdraw their relaxed monetary policies very gradually in the coming months.
The US economy is doing well without additional fiscal stimulus. Unemployment is at a 16-year low of 4.3% and consumer spending is robust. In the euro area, the recovery continues to strengthen and broaden. Brexit negotiations add uncertainty to the region, but the French election result—with a strong, moderate, pro-reform government led by President Emmanuel Macron—has eased political risk substantially.
Japan’s outlook is also improving, helped by fiscal and monetary stimulus as well as solid manufacturing activity and exports. Emerging markets are also doing particularly well. Many EM countries have brought domestic inflation under control and shored up their currencies. As inflation has become more benign, producer pricing power has improved, benefiting EM companies’ margins and driving earnings growth as well as improved credit metrics.
Complex Valuation Landscape
When we look at equity valuations, the picture gets more complicated. Even after this year’s rally, EM stock valuations are still 27% lower than developed-market stocks on a price/forward earnings basis. In developed markets, US stocks are relatively expensive, while European and Japanese stocks are more attractive versus global peers (Display). Still, global equities aren’t particularly cheap when compared to their 20-year history.
At the same time, equity market volatility has fallen to extreme lows, both in the US and globally. But we are concerned that investors are too complacent. There are real risks lurking beneath the surface.
In China, for example, rising debt levels have raised concerns among investors about the stability of the country’s banking system, which could destabilize the world’s second largest economy. In the US, markets have typically suffered a 10% correction every 33 weeks on average since 1928, yet it’s been more than 60 weeks since the last drawdown of that magnitude. And geopolitics remains a source of multiple tail risks, from terror attacks in Western cities to North Korea’s nuclear ambitions and legislative gridlock in Washington, DC.
Low Volatility May be Deceptive
To some extent, low volatility levels in equity markets reflect investors’ comfort with the path of global economic growth. And of course, continued asset purchases from major central banks also keep equity markets happy.
But investor sentiment is often fickle. Indeed, in the last week of the quarter, concerns that loose monetary policies may soon be ending prompted a rise in US Treasury yields. Banks rebounded, oil prices ticked up and US technology stocks pared their gains.
These aren’t simple times for equity investors. But there are strategies that can deliver through the uncertainty. Look for cheaper pockets of stock markets that may benefit if interest rates rise again. Carefully weigh the potential of relatively expensive individual stocks with growth profiles that could justify the price tag. And consider lower-volatility stocks with attractive valuations that can help cushion the blow from a potential correction. Being aware of today’s complexity can help equity investors fine-tune their allocations appropriately for tomorrow’s changing market conditions.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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