Author: NN Investment Partners
Europe’s two big political events of the weekend resulted in no unpleasant surprises. US political risk could prove to be a more likely source of market tremors in 2018.
Many feared that the recent year or so of relative calm in European politics could end yesterday, with two important political events on the agenda: Italian elections and the outcome of the SPD referendum in Germany. Regarding the latter event, fears turned out to be unjustified. The members of SPD, the German social democrat party, voted by a 2 to 1 margin in support of the party entering another coalition with CDU/CSU. This means the new German government could be formed in a few weeks. The initial results of the Italian elections last night are less straightforward, but consistent with our earlier predictions. The US is looking more likely than Europe to be a source of political risk this year.
Hung parliament most likely outcome of Italian election
Preliminary Italian electoral results at the time of writing suggested there was no clear majority, with a hung parliament highly likely. The centre-right, headed by Forza Italia’s Silvio Berlusconi, looked set to be the largest coalition with around 36%. This group also includes the Northern League and the Brothers of Italy, which in the past have been vocal about their disapproval of the European Union but have recently become less anti-EU in their rhetoric. The anti-establishment Five Star Movement (M5S), founded by comedian Beppe Grillo and now led by Luigi Di Maio, will be the most-voted single party with around 33% of the votes. The real loser is the centre-left coalition led by Matteo Renzi of the ruling Democratic Party, which won only 23%. Digging deeper, a bit of a surprise is that for the first time the Northern League has a wide margin over Forza Italia, meaning the centre-right coalition may take a slightly more populist tone. Also interesting is the fact that Northern League and M5S together would be able to achieve an outright majority. Although such a coalition is highly unlikely, it is a clear tail risk.
Focus has shifted for EU/euro membership to fiscal policy
A hung parliament is clearly not good news for Italy, as it will likely lead to a weak government that won’t be able to pass important reforms, but this was widely expected and should not surprise markets. Talks on potential coalitions or possible new elections will take time and will not be sorted out for few months. The main area of contention will no longer be EU or euro membership, but rather the outlook for fiscal policy and banking unit. Many parties want more room for fiscal easing, which may well bring them into conflict with the European Commission and the core Eurozone countries. The populist parties’ strong gains could result in some short-term weakness in Italian assets, but probably without impact on wider European or global markets. The current upturn in Italy’s economy – and the fact that the country’s anti-EU parties have significantly toned down their rhetoric and no longer want a referendum on the euro – should partly offset increased political uncertainty.
US may become a bigger source of political risk tha Europe
On the other side of the Atlantic, meanwhile, political risk continues to increase. President Trump not only surprised analysts, investors and part of his own staff last week by imposing 10% tariffs on aluminium imports and a 25% tariff on all steel imports, he openly suggested this weekend that he is not afraid of a trade war and he is sure the US would win. However, as everyone else understands, there are no winners in trade wars, only losers.
February frost on equity markets
The early-February correction was most likely the result of technical rather than fundamental factors, but equity markets may have reached a turning point last month. The recent rise in real bond yields has impacted market perception of the inflation/growth picture, and the long period of low volatility may be over.
February may have marked the beginning of a new investment regime for equity markets. Granted, the sell-off early in the month was primarily the result of technical factors and bullish positioning and not a reassessment of the fundamentals. But we cannot ignore the rise in real bond yields, which was driven by an ill-timed expansionary US fiscal policy, a bigger focus on inflation data and subtle shifts in central banks’ language. Moreover, economic surprise data at the end of the month disappointed, even if the absolute level of macro data still points towards robust economic growth. The February frost has left in its wake a worsening of the expected growth/inflation mix. Volatility, which has been ultra-low for some time, may move to more historically normal levels. This is probably the most important message for investors, who may become less willing to take risks (see chart).
Macro, earnings outlook remains solid
Our fundamental view on the market remains constructive, mainly because of the benign macroeconomic environment. Robust growth in all regions is supported by all economic actors – consumers, corporates and governments – so the risk of a recession over the next 12 months is very low. In the past, equity bull markets have turned into bear markets only in times of recession.
Another aspect of this growth outlook is that global earnings are likely to continue their double-digit growth rate. Margins have room to expand, especially in the non-US markets, where wage growth remains modest and cyclical sector earnings are recovering. Modestly higher inflation is also supportive for margins, especially for companies with high operational leverage. Commodity, financial and technology earnings will play a crucial role in the margin recovery.
The going may get tough
Equity markets are probably not in for a smooth ride, though. The business cycle is gradually moving to its next phase. Global monetary policy will move from the current divergence, in which the US is tightening while the Eurozone and Japan are still accommodative, towards synchronized tightening in the first half of 2019. Trends in inflation data will determine central bank behaviour and will therefore need close monitoring. They will also impact valuations, implying that market returns will be driven by earnings developments rather than by higher valuation metrics.
Little room for valuations to rise further this year
Absolute metrics like price/earnings ratios or cyclically adjusted P/E have risen to their highest levels since the crisis. Regardless of the reasons for these elevated valuations – the upward earnings trend, abundant liquidity, low cyclically adjusted earnings in financials, materials and energy – it would be unwise to assume that they will move higher in 2018. If anything, with gradual monetary tightening in a late-cycle environment, such as is especially the case in the US, valuations are tilted to the downside.
Monetary support near the limit
Along with the worsening growth/inflation trade-off, monetary policy may weigh on valuations. Even if policy remains easy on balance and brings no surprises, monetary support has nearly maxed out. The European Central Bank has reduced its monthly purchases to EUR 30 billion and will start phasing out the program in September. The US Federal Reserve will gradually step up the pace of its balance sheet reduction and continue its gradual hiking path. We currently expect four rate hikes in 2018 followed by three in 2019. This is also a risk factor for emerging markets in the form of tighter financial conditions, although the weaker US dollar has acted as a compensating factor that has prevented such a tightening so far.