Near-term market sentiment: Confident. The S&P 500 closed last night on a new all-time high, and global stock markets are in confident mood. In the near-term, the weakest link in the chain are perhaps the FAANGs stocks (Facebook, Amazon, Apple, Netflix and Google (aka Alphabet), whose share price wobble last week is a reminder to investors that valuations on risk assets are at historical high levels. But there are three supportive elements to the current rally, and if they can be maintained I suspect that any market correction over the coming months will be swiftly met with investor buying and a swift recovery. These elements are rising corporate earnings growth, a reduction of geopolitical risk, and continuing very loose monetary policy from central banks.
Broad economic and political assumptions for rest of this year:
1) Global economic data remains robust, supporting corporate earnings growth
Sure, the outlook for the U.S probably isn’t as strong as the Fed maintained last week when it raised rates by 25bp. One senses the policy committee was talking about another country given the weak inflation data, tax receipts and other anecdotal evidence of recent weeks. But the consensus estimate is still for GDP growth this year of 2.2%, compared to 1.6% in 2016, which means continued real year-on-year growth in American corporate earnings is likely. Japan and the euro zone are enjoying solid recoveries, with perhaps mid-teen earnings growth for euro zone regional stock market indices in Q2. All of which helps support stock market valuations.
2) Geopolitical issues worries of earlier in the year have somewhat dissipated
For investors with U.K assets, the principle variable in respect to Brexit negotiations is sterling. This has fallen since the inconclusive U.K general election a fortnight ago, but many would argue that a loss of three U.S cents (to a current $1.267) is quite modest given the media talk of political chaos in Britain, the possibility of a Marxist in No10 by the year end if another election is called, and the now fashionable talk amongst some senior Conservative politicians about the need to slow the pace of deficit reduction. But sterling is supported by a belief that Prime Minister Theresa May’s political weakness will lead the government to tone down its Brexit demands, opting for a ‘soft Brexit’ (ie, perhaps remaining in the customs union). This, the currency markets belief, will be less damaging for the U.K economy and for sterling than a hard Brexit. We will see.
From the E.U’s perspective, the uncertainties over the future of the organisation that haunted European leaders earlier in the year are now banished. Helped by the pro-E.U President Macron’s convincing win of seats in the Assembly National, and Angela Merkle’s positive -if guarded- response to Macron’s call for greater fiscal unity. Polls across the region report an increase in support for the E.U, it seems that the trauma caused by Brexit, migration from Syria, the half-built euro project, and terrorism can be contained.
While some investors will be disappointed that Trump is struggling to get a unfunded tax cuts and infrastructure spending bills through Congress, other – saner- heads will be relieved. An unwarranted Keynsian boost to the economy, which must surely turn to bust as inflation, interest rates and the dollar all march upwards together, has so far been avoided. This is not to argue against funded (ie, fiscally neutral) tax reform and infrastructure spending, but not to argue for deficit financing when the budget deficit is already 3.5% of GDP. Meanwhile in China, perhaps the Achilles Heel of the global economy given its over-leveraged economy, the renminbi has risen slightly against the dollar this year -against expectations- and this has helped to reduce capital flight and to keep money in the domestic economy.
Third, central bank policy will remain loose
Just as 2015 and 2016 began with investors bracing themselves for tighter monetary policy from the Fed than was actually delivered, so 2017 looks increasingly likely to follow in the same vein. One further rate hike this year is possible. A second, as hinted by the Fed last week, is improbable unless we see a sharp acceleration in growth and inflation data. Meanwhile the Fed’s cautious approach to reducing its balance sheet (ie, unwinding the quantitative easing policy) suggests it will focus on not disrupting the bond market. The ECB, Bank of Japan and the Bank of England show little inclination towards policy tightening (Regarding the U.K, CPI inflation of 2.9% in May is likely to be followed by a poor number for June, but after that year-on-year price data should fall as the post-Brexit refendum drop in sterling falls out of the data).
Therefore whichever risk free rate we use when making investment decisions (perhaps government bonds, or bank account deposit rates) will remain low and relatively unattractive compared to stock market investments.