After 2017 proved a banner year for global equity markets, many investors wondered if markets could deliver similar returns in 2018. Global equity markets started the year off stronger than any year in the past two decades. Emerging market equities led the rally, delivering 8.6% followed by U.S. equities with 5.7% and international developed equities with 5.1%. There have only been four years when the S&P 500 has had a better start than in 2018, with each of those years posting double-digit gains in the first month.
Robust earnings, an improving global economic outlook and a weakening U.S. dollar have been driving global equity markets. Based on the 50% of S&P 500 companies that have already reported 4Q17 earnings, over 75% are beating both sales and earnings estimates. Consensus earnings estimates for 2018 have increased across all regions of the world, led by the emerging markets and the United States (Figure 1).
Further supporting the strength in emerging market equities and large-cap U.S. equities has been the decline in the dollar measured by the narrow U.S. Dollar index, which has fallen by 13% since early 2017 with a 3% decline just in January. The majority of the recent dollar weakness is attributed to the sudden strength in the euro. Capital flows into Europe largely explain the recent appreciation in the euro given higher than expected growth in the euro area. Furthermore, the widening U.S. fiscal and current-account deficits act as headwinds to dollar appreciation. All this continues to reinforce our long-term dollar depreciation view as the dollar exits from its previous seven-year bull market.
The durable nature of this global economic recovery has re-stoked inflation expectations, bringing 10-year U.S. Treasury yields to a three-year high of 2.73% (Figure 2). Although bond market investors were stubborn for most of 2017, pinning yields to a range of 2.0– 2.6%, the breakout to 2.7% and above shows that the bond market is starting to agree with the equity markets that global economies are likely to finally grow above trend. We expect yields to continue to drift higher.
The logical question after such a heady start to the year on top of already strong gains in 2017 is, what type of upside is left or are the equity markets vulnerable to a correction? We answer that question with our investment process framework of valuations, fundamentals and sentiment.
Valuation is high on most measures such as the Shiller PE, price/ book and price/earnings ratios and can act as a headwind to forward equity returns over long-term investment horizons such as ten years. In the intermediate term of one to two years, valuations tend to be a fickle if not poor indicator for forward looking returns. In the world of multi-asset investing, however, equities are clearly more attractive than bonds; bond yields are far too low given the economic outlook. The sharp move higher in bond yields has begun to leave investors questioning at what point it will begin to impact equity valuations. Although it’s difficult to point to a critical level, it is important to note that the move higher has been driven mostly by the continued momentum in global growth, which is a positive for equities.
Fundamentals — which incorporate monetary policy rates, earnings, business investment and consumption — are strong and improving. Global activity remains supportive, with upward revisions to growth estimates across regions. The same can be said for earnings revisions as the trend remains higher across the majority of the markets we track, while higher commodity prices and a weaker U.S. dollar should continue to be tailwinds for earnings in the near term.
Sentiment across a number of our indicators is fairly extended, as we have seen record inflows into equities to begin the year. While we are mindful that these conditions leave the market vulnerable to a shock, using these indicators to time the onset of a correction has proven less effective.
Our portfolio remains positioned for a positive global growth outlook. Our long held constructive view on the emerging markets remains, even in light of some temporary relative weakness. We think economic data are still a positive and not too much of a good thing. While mindful that the cycle may be late in calendar years, we see our economic activity models and earnings projections telling us equities can stay well supported.
In summary, we are mindful of risks on the horizon given the current state of our sentiment indicators. Nevertheless, we are comfortable with a positive bias towards equities, given the relative valuations of equities versus bonds and the fundamental underpinning of a strong global growth environment.
Multi-Asset Strategies and Solutions Team
Voya Investment Management’s Multi-Asset Strategies and Solutions (MASS) team manages the firm’s suite of multi-asset solutions designed to help investors achieve their long term objectives. The team consists of 25 investment professionals who have deep expertise in asset allocation, manager selection and research, quantitative research, portfolio implementation and actuarial sciences. Within MASS, the Asset Allocation team, led by Barbara Reinhard, is responsible for constructing strategic asset allocations based on its long-term views. The team also employs a tactical asset allocation approach, driven by market fundamentals, valuation and sentiment, which is designed to capture market anomalies and reduce portfolio risk.
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