Sanguine market response to the Fed’s interest rate hike and Trump reflation exuberance continues to fade
Despite a strong first quarter for global equity markets, the Donald Trump reflation exuberance has continued to fade in recent weeks. With Trump yet to complete his first 100 days in The White House, his credibility has already come into question. US equities appear to be fuelled on the hope, rather than expectation, that Trump can deliver the key fiscal stimulus measures that will lead to higher growth. There has been a notable divergence between ‘soft’ (survey based) and ‘hard’ (quantifiable) economic data, with the former ratcheting higher and the latter pointing to a notably weak first quarter GDP figure. Tighter financial conditions experienced towards the end of 2016 appear to have impacted the US economy. The next few months will be a key test for Trump and the sustainability of the reflation trade.
US equity outlook
On the positive front, there has been a relatively sanguine market response to the Federal Reserve’s (Fed) largely expected interest rate hike in March. The Fed expressed their desire to proceed with caution and still expect rates to peak at just 3% during this cycle. Although this remains above current market expectations, the Fed appears to have struck the right tone between keeping policy accommodative and remaining positive on the economic outlook. Our main area of caution is US equity market valuations. Despite heightened expectations; we have seen analyst forecasts drift lower. With US equity valuations looking stretched and moving to a wide premium to the other developed markets,we will need to see earnings upgrades in the US to alleviate valuation concerns. Much appears to be priced into markets leaving scope for disappointment.
UK and Europe outlook
With Theresa May officially handing over the Brexit divorce papers to the European Union, the tone of subsequent negotiations will be the focus for markets as the year progresses. We expect very little in the way of substantive news flow in the near-term but the early conciliatory tone from both sides has been encouraging. The more immediate focus for the UK is the impact of the squeeze on real incomes. With inflation outpacing wage growth, we are already seeing signs of the UK consumption growth losing momentum. At 2%, we believe the Bank of England’s 2017 GDP forecast remains too optimistic and the headwinds facing the consumer could force the bank to backtrack towards their previous forecast of 1.4%. Longer-term UK bond yields (a proxy for GDP growth) have responded to the uncertain economic outlook by moving lower. UK equity market valuations still look relatively attractive and a weak sterling continues to support earnings for the more internationally-exposed FTSE 100. But given the headwinds facing the UK consumer, we have a more cautious stance on the outlook for more domestically focussed UK companies.
Political concerns in the Eurozone have continued to subside. However the French election could still produce a scare for markets if Macron (the current clear favourite) started to lose momentum ahead of the first round vote on 23 April. It has been encouraging to see the continued improvement in Eurozone economic data and should this cyclical rebound in the economy persist; this should continue to support sentiment towards Eurozone equities which have performed well in Q1. With improving earnings estimates and attractive valuations relative to the US, we remain positive on Eurozone equities. The improving growth and inflation outlook in the Eurozone could lead to a more hawkish (or notably less dovish) stance from the European Central Bank (ECB). We still believe the ECB will maintain an accommodative stance.
Emerging markets have been a key beneficiary of the weaker dollar and have outperformed their developed market peers year to date. Further signs of stabilisation in China have also helped buoy emerging markets. A relatively quiet and stable period for the Chinese economy has been a positive and has supported the global reflation theme. Capital outflows appear to have also stabilised in recent months but the high levels of debt in China remain a lingering concern. An inflating housing bubble and a surge in credit could force the authorities into tightening monetary policy later in the year, potentially curtailing economic activity.
Looking ahead, markets appear willing to give the Trump reflation trade the benefit of the doubt and volatility has remained at relatively low levels, however we sense patience will soon wear thin going into the second quarter. Any positive impact from what is likely to be a watered down fiscal stimulus plan could now be delayed until late 2018. With US equity valuations looking rich, we believe there is more than enough scope for a period of heightened volatility should news flow continue to disappoint. Although we remain more positive on Eurozone, Asian and emerging markets, the strong relationship between global equity market performance means it’s difficult to see wider markets sustaining the rally without the US leading the way. With this in mind, we continue to see the benefits of holding a more balanced portfolio of equities, bonds and alternative assets, such as absolute return funds, to help ease volatility