US equities hit record highs as Atlantic divide sharpens
Concerns over the more hawkish tone from central banks which jolted markets in early July have eased in recent weeks with the focus shifting on to a busy period for company earnings. A slowdown in inflationary pressures has prompted markets to maintain the view that the punch bowl of central bank asset purchases and low interest rates will not be taken away anytime soon.
A key theme for markets has been the continued weakness of the dollar and the strength of the euro. This perhaps reflects the diverging sentiment between the political and economic outlooks of the two regions.
While the Eurozone’s economic recovery continues and the political landscape stabilises, Donald Trump’s position in the White House looks increasingly precarious and prospects for fiscal stimulus in the US continue to fade. The dollar has fallen 8.5% against a basket of other major currencies so far this year.
US equity markets have again hit record highs driven by a strong performance from more cyclical (growth sensitive) sectors including financials and technology. This has been somewhat at odds with the economic picture in the US, where the data has continued to come in on the weaker side.
The US technology sector has now risen past the highs of the late 1990s/early 2000s, however valuations for much of the sector don’t look overly stretched relative to the historic levels. Investors, for now at least, appear content with companies that provide higher levels of earnings growth and more consistent cash flow. Inflation in the US has continued to fall in the first half of the year. Indeed the Federal Reserve (Fed) appear to be acknowledging the recent weakness could persist. With little sign of wage pressures coming through, despite unemployment at just 4.4%, we believe the inflation remains too weak for the Fed to pursue anything other than a gradual path for interest rate hikes.
The Fed could well begin the process of slowly reducing the size of its $4.3tn balance sheet in the coming months. The Fed is likely to let a small amount of maturing bonds run off each month but the process is likely to move at a glacial pace and is unlikely to be a hugely disruptive event for markets. Financial conditions (low bond yields and weaker dollar) have eased which should help support US companies; however the strong rebound from a weak first half of the year for the US economy is still proving elusive.
Despite sentiment towards the Eurozone continuing to improve, the region’s equity markets have underperformed in recent months. The unrelenting strength of the euro, which has risen over 10% versus the dollar so far this year, could well be beginning to weigh on the export-reliant companies that dominate the Eurozone’s equity markets.
On most long-term metrics the euro remains undervalued (relative to the dollar) and the European Central Bank (ECB) appears comfortable with the recent rise. However with inflation currently well below target, the strength of the currency could begin to feed into the ECB’s thinking should it continue to rise. ECB president Mario Draghi gave little indication that a change in the central bank’s policy is imminent at July’s meeting, however focus will be on September’s meeting for strong hints that the ECB will to begin tapering back asset purchases early in the New Year.
We remain positive on the region’s equity markets, however with high expectations comes scope for disappointment. The earnings profile for the region remains positive and valuations are relatively attractive which should continue to support Eurozone equities, however returns in the second half of 2017 might not match the stellar start to the year. The IMF became the latest major organisation to lower its UK GDP estimates for this year to 1.7%. Growth next year is expected to remain on the weaker side at 1.5%.
The first estimate of second quarter GDP came in at 0.3%, showing the UK has slowed in the first half of 2017 but the economy appears to be displaying some resilience against a backdrop of political uncertainty. Although inflation eased back in June, real disposable incomes continue to be squeezed and the household savings ratio is at a 50 year low of just 1.7%.
Despite two more Monetary Policy Committee (MPC) members voting for an interest rate increase last month, producer input prices (which generally lead headline consumer prices by around three months) fell sharply in the first half of the year suggesting CPI inflation could follow soon. This could well result in the Bank of England lowering their inflation forecast in August’s Inflation Report. With this in mind, we believe the balance on MPC will tilt back towards a dovish majority and rates will remain on hold for at least the remainder of the year.
Official Brexit negotiations have now begun but there has been little of substance so far through the noise in the headlines. Brexit continues to be the source of fragmentation within the government, meaning the UK’s preferred strategy remains unclear. Sterling is likely to remain range-bound while the political uncertainty persists. October is likely to be a key month with the Conservative party conference taking place and a summit of EU leaders. This is most likely the earliest date for negotiations on a trade deal to begin.
Emerging markets have continued to outperform their developed market peers early in the third quarter. The weakness of the dollar and firmer commodity prices have helped boost the performance of emerging market equities in recent months. Further signs of stabilisation in China have also helped to improve sentiment towards the wider emerging markets space.
Company reporting season has been the focus for markets in recent weeks. At the time of writing, over half of the S&P 500 has reported numbers. So far, we have seen revenue growth of 6%, and earnings growth of 10.6%, with over three-quarters of companies beating (lower) analyst estimates. Gains have largely been driven by another solid quarter for the US technology sector, which accounts for around 25% of the US market.
Overall, many of the sector’s bigger names are likely to continue to deliver high levels of earnings growth, but looking ahead, there is greater scope for disappointment, should companies fail to meet ever growing analyst expectations.
Bond yields (which move inversely with prices) have stabilised inJuly, following a sharp rise at the end of June. Expectations of tighter policy from the developed world’s major central banks have eased back recently, with both the growth and inflation outlook still remaining uncertain. With 10-year yields (a proxy for economic growth) still at low levels, the message from the bond market remains that growth in the developed world is likely to remain on the weaker side, going into the second half of 2017.
The Fed’s recent policy statement appeared more cautious, and markets have lowered their expectations for another interest rate hike this year. While the Fed is still projecting a further four hikes by the end of 2018, the market is currently pricing in just one more. We suspect this gap will narrow at September’s FOMC meeting with the Fed moving more in line with market expectations, as we’ve seen in recent years, when the Fed has tended to over-estimate the tightening required.
Dollar weakness has remained a major theme for markets going into the third quarter of the year. Weaker US data, declining interest rate expectations and growing risks of disappointment on fiscal stimulus in 2017, have caused the dollar to fall to a two and a half year low versus the euro. Sterling also appears to have broken out above its recent resistance level of 1.30 versus the dollar, after rising 1.5% in July.
Sterling could now trade within the 1.30-1.35 level seen in the third quarter of 2016. Sterling has weakened against the broad strength of the euro, approaching the lows of 1.10 seen in October, despite interest rate expectations in the UK actually rising relative to those in the Eurozone in recent months. This suggests a key driver behind the two currencies remains politics. With this in mind, the momentum is likely to remain behind the euro while the cloud of uncertainty still remains over the UK’s approach towards Brexit.