Near-term market sentiment: Confident, with risk assets still in demand. The S&P500 continues to reach new highs and U.S corporate bond yields are touching new lows. In the ‘real’ economy Doctor Copper – so called because moves in the copper price have historically foretold changes in global output and GDP- is giving a positive prognoses, with the copper price at a two-year high. A weak dollar is currently supportive. However, investors should remain diversified with exposure to both defensive assets (eg, government bonds and cash) as well as risk assets (eg, stocks and high yield bonds), given the unpredictability of market movements. The model portfolio below offers a guide as to how to achieve this.
Why have markets defied expectations? The year-to-date returns from global stock markets have exceeded the cautious expectations posted at the start of January. The MSCI World index of developed stock markets is up 13% in USD and 10% in local currency, with gains evenly spread by geographical region. The MSCI Emerging Markets index is up in 25% USD and 20% in local currency terms, reflecting investors’ appetite for risk.
Gains have been driven by relief that some of the bad things forecasted have not materialised. For example, nationalist parties did not take power in the Netherlands and France. Instead investors in continental Europe were delighted when the centrist and pro-E.U Macron won the presidency and then a parliamentary majority. Trump did not announce 40% tariffs on Chinese imports on taking office and has not done anything too damaging as yet to the domestic or global economy, and the Chinese financial sector has not collapsed under the weight of bad debt. Perhaps of greatest impact, the Fed has been more cautious over the outlook for future interest rate hikes, suggesting that cheap money may be around for longer than previously expected, so adding impetus to the ‘search for yield’ that has driven the rally in risk assets since 2009.
There have also been surprises: U.S and global corporate earnings growth has been stronger than expected, reflecting solid growth in global demand. The recovery in demand within the euro zone continues, with euro zone GDP now running at a touch above 2% year-on-year, which is comparable with the U.S and above the 1.7% recorded for the U.K. By the end of last week 56% of the S&P500 had reported their second quarter earnings results, representing 70% of the index by market capitalisation. 73% of these companies had exceeded expectations.
Can stock market gains persist? The world’s largest market -the U.S, which currently makes up 59% of the MSCI World index – is richly priced, both on a forward price/ earnings multiple and using cyclically adjusted earnings. But mispricing – if that is what it is- can persist for a long time. As long as bond yields remain low, and the Fed remains cautious, the search for yield will continue to support global stock markets. The Fed’s own valuation model shows stocks attractively priced compared to bonds: 10-year inflation linked bonds yield 0.47%, while the S&P500 dividend yield stands at 1.9%. The lack of progress by Trump and Congress in passing fiscally-simulative policies will continue to lead to downgrades of future GDP growth forecasts for the U.S, but this has probably been already priced into the most affected stocks as well as into the dollar.