Author: NN Investment Partners
The US government’s ineffectiveness and North Korea’s geopolitical threats may be making markets risk-averse. In contrast, downside political risk in Europe has declined this year.
Equity markets continue to benefit from positive flows of macroeconomic data, monetary policies that are still accommodative and a fairly sunny outlook for corporate earnings. Behavioural indicators present a mixed picture, with the bull/bear mix showing signs of pessimism and sentiment readings giving a negative signal, despite continuing inflows. The international tension surrounding North Korea’s missile tests highlight the global geopolitical risks that loom over the market. Another observation relevant to equity markets is shifts in perception of political risks. Perceptions of the US politics have shifted so that hopes of reflation and tax reform have been replaced by disappointment with an ineffectual government. In Europe, on the other hand, political risks have diminished sharply this year. With a series of key elections drawing to a close, the region may be better positioned than any time since the financial and euro crises to fortify its shaky institutions.
Europe political risk shifting to the upside as Germany votes
The year 2017 was supposed to be the year of political risk in the Eurozone. In May, the UK invoked Article 50, starting the clock on a difficult two-year process that will ultimately lead to the kingdom’s withdrawal from the European Union. On the continent, elections scheduled in several key member states were seen as a test of the union’s standing among its electorates in the face of the wave of nationalism that led to the Brexit outcome in last year’s referendum and that swept Donald Trump into the White House.
There is so far little to say of Brexit, except that no progress has been made and the clock is ticking. Financial markets are not much bothered. UK equities trade primarily on international factors, and the Eurozone benefits from a strong domestic situation and is seen as having the stronger hand in the negotiations. The elections in the Netherlands and France went well, as voters in both countries largely rejected the anti-EU message of populist candidates Geert Wilders and Marine Le Pen.
Federal elections will be held in Germany on Sunday to elect the members of the Bundestag, which will in turn elect a Chancellor who will form a new government. Angela Merkel’s CDU party is likely to be the winner next weekend, having maintained a double-digit lead over the SPD in opinion polling since the 2013 election, apart from a period in early 2017 after Martin Schulz was selected as the social democrats’ leader. The main question concerns the composition of the new government. Who will be the main coalition partner? The liberal FDP party together with the Greens, or the SPD in a “grand coalition”? This choice could, in concert with the programme of France’s still-new President Emmanuel Macron, set the stage for a deepening of the Eurozone institutions. If Macron can make good on his pledge to structurally reform the French economy, a new Merkel-led government may be open to increased risk-sharing among members of the monetary union. Political risk in Europe may have shifted to the upside. Election-driven risk aversion has undoubtedly helped keep Eurozone bond yields low this year. This factor has faded with the positive election outcomes we have seen so far, although Italian elections will be held in the first quarter of next year and election fever may flare up again sometime in the coming six months. For markets this is too far in time to be really concerned about today.
Macro data remain favourable, earnings outlook positive
Several other observations are relevant for equity markets. One is that macroeconomic data have in general surprised to the upside over the past month. Inflation remains stubbornly low, leading to unimpressive nominal growth figures. The weakening link between the low unemployment rate and the trend in wage growth is evident in the US, Japan and Europe. It continues to puzzle economists, and it makes life difficult for central bankers, who see on the one hand global economic recovery, high confidence indicators and better growth in loans and exports and, on the other hand, low inflation figures that give them little reason to tighten monetary policy. For the European Central Bank, policy is also complicated by the strength of the euro and its downward impact on the inflation expectations. In our view the probability of a dovish surprise has gone up. For corporates, the low-inflation environment is a two-edged sword. On the negative side, it limits top line nominal growth. On the positive side, it helps profit margins, as wages are the biggest cost driver for most companies.
Corporate earnings growing in double digits in US, Eurozone
Another observation relates to corporate earnings growth. For the first time since 2011, earnings are growing at double-digit levels in the US as well as in the Eurozone. In addition, earnings momentum – i.e., the ratio of upgrades relative to downgrades – has improved in the past month and is currently positive for every single region, including emerging markets. For Eurozone earnings this may be somewhat surprising given the strength of the euro but it illustrates that the tailwind of higher growth is stronger than the currency headwind. The picture changes if we look at 2018 estimates. As illustrated in the graph, earnings for Eurozone companies are expected to grow less than global earnings and US earnings. This makes sense as currency movements are a slow-burning issue where Eurozone pain is US gain.
Valuations are subject to discussion. In an absolute sense, price earnings ratios are high but not extreme. Relative to fixed income instruments, equities are in line with or more attractive than historic averages. This is especially the case for the Eurozone and Japan. The US equity risk premium is somewhat below average. What is sure is the fact that long term return expectations have shifted down. This is not surprising given the year-long rally we witnessed and the impact of a lower nominal growth environment. For the US and the Eurozone, the expected long term return is below 6% whereas in Japan it is above 6.5%. This is short of the past trend rate of return.
Behavioural measures show mixed picture
The behavioural side of the equation is mixed. The bull minus bear indicator of US individual investors indicates some pessimism, without being at contrarian levels. Our sentiment indicator, however, continues to give a negative signal. This signal is based on an analysis of news and social media articles. Futures positioning is also high and short-term price momentum is negative. The flow picture looks somewhat better. Of the past 12 weeks, 11 saw inflows. Nevertheless, these flows are shifting away from the Eurozone towards the rest of the world, including the US.
We have a fundamentally positive picture combined with short-term behavioural indicators that warrant some caution. But what about the risks? North Korea poses a geopolitical risk, but the impact of international tension on equity markets is becoming less and shorter in time. The rhetoric has been provocative, but in the end sanctions are likely to remain limited to political measures and trade restrictions. A further sharp drop in the USD is another risk. Finally, a monetary policy error cannot be ruled out either and this would represent a serious shock to investors’ confidence.