We expect global equity markets to grind higher during 2018, while interest rates and commodity prices will likely remain range bound. At this time, we are emphasizing areas of the markets that lagged in 2017, such as U.S. small- and midcaps, as well as value. Global economic growth appears stronger than many expected, and we think that trend will continue. Therefore, we anticipate some of those areas that have lagged may soon lead the markets. We expect this continued growth in the global economy to endure for three important reasons.
First, central banks continue to employ stimulative policies that should allow economic growth to remain in place. While the U.S. Federal Reserve (Fed) is expected to raise interest rates further and slowly reduce the size of its balance sheet, both the European Central Bank and the Bank of Japan continue to supply the global economy with additional stimulus through low interest rates and balance sheet expansion (exhibits 1 & 2).
Secondly, we think the U.S. economy is strong and can support corporate earnings growth and higher stock market prices. Borrowing costs and inflation remain low, while labor markets continue to improve. Therefore, household spending should continue to drive economic expansion (exhibit 3). In addition to consumer spending, we expect business investment to continue its advancement (exhibit 4). Recently enacted tax reform will likely have a positive, though marginal, near-term impact on the economy. As a result, we think U. S. real GDP growth for the remainder of 2017 and 2018 is likely to be around 2.0% – 2.5% annualized. This should be enough growth to allow for continued earnings improvement, but hardly enough growth to spur significant inflationary pressure (exhibit 5).
Finally, the global leading economic indicators that we track suggest continued economic momentum as we enter 2018. For example, the latest reading of the JPMorgan Global Manufacturing PMI, based on November data, indicates an increase in the rate of global manufacturing production, which rose to levels not seen since February 2011 (exhibit 6). Improvements in global growth have been led by the euro zone where output expanded at the fastest pace in more than six years with increases in activity across the continent’s major economies including Germany, France, Italy, and Spain. Positive trends in new orders is straining capacity and has increased the backlogs globally. This trend has encouraged jobs creation around the world.
This advancement in the global economy should create a favorable atmosphere for equity investors. While we remain constructive on near-term economic fundamentals, stock market volatility can increase at any time. Credit spreads, the difference between corporate bond yields and Treasury yields, tend to lead equity market volatility, but currently project market stability for the months ahead (exhibit 7). Tight credit spreads continue to suggest that any stock market selloff will likely be contained. We think that profits can be made in these markets, but it may not be glamorous, more likely it will be a grind.
The environment will get more interesting later in the year after the Fed hikes rates further. Unless monetary conditions and the yield curve become more accommodative to rate hikes and a balance sheet reduction, the Fed might be in danger of overtightening policy and choking off liquidity. For example, historically the yield curve, which is the comparison of rates at various maturities, has been a good leading indicator of U.S. economic activity (exhibit 8). When long-term rates are significantly higher than short-term interest rates, which results in a positive slope to the curve, future economic growth has generally been solid. However, a flat or inverted yield curve, where long-term interest rates are lower than short-term interest rates, has been a leading indicator of economic difficulty and recession.
Our base case is that the Fed will not make such a serious error, but as we manage risk in real-time, we will make tactical changes quickly should the need arise.
INVESTMENT IMPLICATIONS
Within our equity allocations, we are favoring the health care, industrials and materials sectors. We think that industrial and materials stocks can benefit from the improving global economic growth trends highlighted above. Additionally, we recently purchased an investment focused on dividend-paying technology stocks. Despite consistent upside earnings surprises from these large and stable information technology companies, these stocks have underperformed the broader technology sector, which we think will reverse in the near-term. These companies may also benefit from tax reform, especially as it pertains to repatriating foreign earnings. Finally, we maintain our general value bias despite it lagging growth recently. We think the recent outperformance of domestic growth stocks relative to value has mostly run its course.
In general, U.S. equities seem a little expensive to us, though we are interested in the sectors previously mentioned. We are finding interesting opportunities in Europe and Japan, where valuations remain attractive and economic fundamentals are improving. We are not long-term bulls on either region, but find them favorable for the time being.
While domestic equities and emerging market stocks are trading at a premium to their historical average valuations, both Europe and Japan are trading at discounts (exhibit 10). Emerging markets have surged recently, and we think their return expectations over the near-term should be lowered, especially since several central banks in emerging Europe and emerging Asia are looking to tighten monetary policy. As a result, emerging market stocks is one of our larger underweights.
Regarding our fixed income and alternative allocations, tight credit spread and low interest rates continue to create a challenging environment for traditional fixed income investors. Our well diversified, strategic/tactical approach has allowed us to take advantage of several return-enhancing and risk management opportunities in broadly diversified ETFs that blend allocations to REITs, MLPs, and dividend payers, as well as more focused holdings, like convertibles, bank loans, and preferreds.
THE CASH INDICATOR
The Cash Indicator (CI) has moved up slightly, but is still a long way from signaling significant equity market risk ahead (exhibit 11). Keeping in mind that the Cash Indicator is a measure of fear and volatility in both equity and credit markets, the low volatility environment has us fully invested. The CI is supportive of our base case for slow and steady growth. At these levels, we see any near-term volatility as healthy and necessary for global markets to continue their upward trend.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.
Index Definitions:
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
MSCI Europe Index – This Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe. With 445 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.
MSCI Japan Index – This Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 321 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.
MSCI EM Index – This Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. With 837 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.