Outlook 2018: Global equities
If global equities tiptoed into 2017, they certainly broke into a run as the year progressed. In the first quarter of 2017, the MSCI World index rose 5.9%. This was a bigger return than the whole of 2016. In total, the index has risen by over 18.6% to 1 December1.
Much of the climb was justified by improving fundamentals:
Economic growth continued to gather momentum while inflation has remained stable. Although the Federal Reserve (Fed) and the Bank of England have recently raised rates, other major central banks have persisted with expansionary support.
Perhaps most importantly, the synchronised recovery in global growth has translated into better earnings. In September, consensus analyst forecasts anticipated earnings growth of 15% for 20172. We think this looks fair.
In addition, the major European elections largely passed without incident, allaying lingering political concerns. France and the Netherlands both voted against the rising populist tide that had significant potential to destabilize markets.
Tricky next steps
Overall, we remain optimistic when looking at prospects for 2018 but we are cognizant of potential risks. Dispersion and volatility are likely to rise as the market cycle matures.
One of the main risks is complacency itself. While stock valuations are fundamentally supported, they are undeniably elevated when compared with long-term averages. Even when cyclically adjusted, valuations – as measured by price/earnings ratios – are close to the top of their historic range. This suggests there is little “wiggle room” should things go wrong and, eight years into a US bull market, the risks of a reversal are clearly rising.
Another concern is borrowing. Overall debt burdens have broadly continued to climb since the end of the global financial crisis. Given that it is now likely a question of “when”, rather than “if”, central bank policy is tightened, we believe the market is underestimating the negative impact from rising rates.
For example, it is noteworthy that the one key financial metric currently “flashing red” in the US, versus previous peaks in the market, is non-financial leverage. Rather than invest in new capital equipment, many US corporations have levered up balance sheets to buy back shares and/or raise dividends: helpful for stock prices, but not sustainable over the medium-term, especially as rates rise.
Debt has been creeping upwards
Source: Schroders/Citi Research November 2017
On a global basis the environment appears more benign. Indeed many regions continue to demonstrate a strongly positive rate of change in economic growth – even in “Old Europe”.
The backdrop is therefore one of reasonable stability with the potential for bouts of short-term volatility. In contrast to 2016, when liquidity fuelled a highly correlated rally in certain cyclical sectors, 2017 has been a year of dispersion. The market has rewarded companies showing continued execution in terms of revenue, earnings and cashflow growth, whilst punishing those that disappoint. 2018 is likely to remain a favourable environment for stock-pickers, in our view.
As ever in global economies, there are a number of structural trends that could be important drivers for equities next year.
Growth in social media and online platforms has been sapping growth from other industries for some time. But what was initially a disruptive nuisance now poses a full-blown existential threat to players in industries like retail, legacy media, distribution and traditional banking.
There has already been massive compression in the valuations of those companies facing direct competition from new technologies. As that footprint widens, there are likely to be further substantial opportunities; either in the active disruptors themselves or for those traditional businesses prepared to sacrifice near-term profitability in order to innovate and stay competitive. Those that do not will almost certainly find that the foundations on which they were built will be swept away with alarming rapidity, as swathes of the US (and UK) retailing sector have found to their cost,
Taming the internet giants
In June 2017, the European Council fined Google €2.4 billion3 for abusing its dominance as a search engine. Although that it is clearly a large sum, the significance of the fine for Alphabet (Google’s parent) represents less than 35% of the operating profits of the business in Q2.
Other internet companies have similar extraordinary earnings power. Strong revenue, pricing power and relatively little capital employed creates a compelling mix for shareholders. With high margins, high cashflow generation and high return on capital it is no wonder that many of the largest internet companies, as well as generating outstanding returns, have attracted the attentions of regulators around the world.
The latest EU ruling probably represents a sea change for the major internet platforms. Although they remain behind the curve, regulators are now trying to get to grips with the power and impact of these massive companies. It is likely that further challenges await.
We anticipate a major transformation in the energy and automotive industries over the next two decades. A very powerful combination of competitive renewable energy, improving battery storage costs and desirable electrically powered vehicles is emerging to forge a viable path towards de-carbonisation of energy and transportation. However, we do not expect the transition to be linear. Navigating the transition may be as much about avoiding the losers, as finding the winners.
Pick your battles
Investors in global equities have a lot to be positive about in 2018, but should be aware that this optimism is widely shared around the market at this time. It is a truism that just as exuberance can be become irrational, so fundamentals always prevail in the end. “Mean reversion”4 is a given in equity markets and earnings power varies widely through the cycle and from sector to sector.
Our investment philosophy is predicated on the notion of “un-anticipated growth”. The market is often myopic, focused on the “now”, and failing to look ahead. The relative strength of individual business models is often over-looked, as is the potential for change to create new opportunities in areas hitherto seen as ex-growth, or dull.
Innovation is always at the heart of sustained growth. For companies to enhance the durability of their earnings over the long term, we believe they need to deliver innovation. Companies that innovate successfully are likely to be significantly rewarded by investors: those that don’t will almost certainly be over-whelmed by the pace of change.
Well-managed companies, with cultures that support ongoing innovation, performance and accountability, will be better placed to deliver superior returns irrespective of the economic cycle. Our focus will continue to be on searching for these individual situations that fit our investment philosophy on a global basis, rather than attempting to time allocations to regions or sectors. In a globalized world, there are always opportunities at the company level.
The full range of our Outlooks 2018 series of articles is available here.
1. Bloomberg, December 2017↩
2. Citi Investment Research, September 2017↩
3. European Commission press release, June 2017↩
4. Mean reversion – while not guaranteed – assumes that valuations usually return to their longer-term averages over time.↩