NN IP: Bubble Time

Do not be fooled by the title, unless you were thinking about bitcoins, paintings or soccer players. The bubbles I refer to are liquid and consumed in large quantities this time of the year. Equity investors have plenty of reasons to be cheerful and raise the glass. 2017 will go into the books as a year to remember. Global equities rose more than 16% and emerging markets even 25%. The biggest upside surprise came from the US, helped by business friendly policies (financial deregulation is back on the agenda and this week the tax plan was approved) whereas the Eurozone lagged our expectations (in a relative sense, not in absolute terms!) despite the successful passing of many political hurdles, a broadening growth improvement, easy monetary policy and an attractive equity risk premium. Emerging markets were the best performing region. Easy financial conditions, a weakening US dollar, strong earnings growth, attractive valuations and good economic data all acted as tailwinds for emerging markets. We should also not forget the strength in the technology sector as this has now become the biggest sector in emerging markets, representing around 30% of its market cap. Globally, technology dwarfed the performance of all other sectors.

The big question is of course whether this trend can continue. We are not too much worried about the short term. Global earnings momentum is picking up and all regions are currently seeing more upgrades than downgrades. The macro picture is also encouraging and remains of the Goldilocks-variety. This was once again confirmed by the Fed and the ECB last week. Both central banks upgraded their growth forecasts, but were more doubtful on the near-term inflation outlook. This means that we do not expect a shift in policy from the current gradual path. The ECB will scale back its QE program and the Fed will, in addition to three expected rate hikes in 2018, step up the pace of balance sheet reduction. If history is any guide, the impact of this on the market is twofold.

First of all, tighter monetary policy may dampen the valuation metrics. We would be very surprised if in 12 months’ time the price/earnings ratio is above current levels, especially in the US. In other words, we do not expect market performance to exceed the growth in earnings (around 10% globally). In the US we are entering the late-cycle phase in earnings. The tax plan will only push the deceleration in earnings growth one year forward. 

 Secondly, tighter monetary policy can feed through into the relative strength of sectors. Defensive sectors and bond-proxies tend to lag cyclicals and financials in this policy environment. However, cyclical sectors have already massively outperformed defensive sectors and positioning is stretched. This was confirmed by this week’s fund management survey. Although positions are less stretched than the previous month, being overweight cyclicals and financials is still very much a consensus positioning. This pleads for moderation in our cyclical exposure for the time being. 

Figure 2 illustrates that the relative sector performance has to a large extent already anticipated the monetary tightening. However, the same graph also shows that, historically, this sector performance does not reverse until short-term rates reverse.

The medium-term challenges are diverse. As always, politics will at times dominate headlines. In the short term, we have the regional elections in Catalonia and the coalition talks in Germany. In Q1 there will be elections in Italy and of course the US mid-term elections in November. In emerging markets we also have a flurry of elections (Mexico, Brazil, Russia,…). Given the strong economic backdrop we do not expect these political events to derail the market but only to inject more volatility. The biggest risk factor to watch out for will be inflation. An unexpected surge in inflation could lead to a reassessment of monetary policy, forcing central banks to hit the brakes. If this would lead to an economic slowdown, the bull market in equities is in serious trouble due to the combined headwind of lower valuations and lower earnings growth. Until then, enjoy the party and dance to the music.