World equities recovered strongly over the past month after the setback in August and early September caused by the North Korean missile tensions. Emerging markets have led the way, especially Brazil and India, while the S&P is also up strongly in the period.
Currently the MSCI World Index of developed economies is up 5.8% from its North Korea related low on August 21. For the year to date, the index is up by 13.1% in its local currencies and by 16.2% in US dollar terms, 18.1% including the taxed value of dividends.
By region, American shares have performed strongly: the S&P 500 is up 15.0% in capital value for the year to date. Technology has been in especially high demand, with the Nasdaq’s tech stocks up 32.9% and its biotech shares up 25.2%. European shares, as measured by the FTSE Eurofirst300 Index, are up by 7.2%. Eurozone markets have reflected the improving eurozone economy, with German shares up 13.2% and French shares 10.5%, but UK shares have lagged on Brexit uncertainties, with the FTSE 100 Index up by only 5.3%. Japanese shares, which had meandered for most of the year, have risen sharply since Prime Minister Shinzo Abe called a snap general election on September 25, and the Nikkei index is now up 12.3% for the year to date.
Emerging markets have done even better again. The MSCI Emerging Markets Index is up 25.6% in the emerging markets’ own currencies and by an even stronger 29.9% in US dollar terms. The main BRIC markets have led the way, with the Brazil Bovespa Index up 26.8% and India’s Sensex Index up 21.6%. Meanwhile, the Shanghai Composite in China is up 8.9%, but the FTSE Russia Index is up just 3.3% but the RTS Russia Index down 1.6%.
Trade and Tax Are Positive Signals
The global macroeconomic outlook remains supportive for equity performance. The October forecasts from the IMF said that global growth is strengthening:
“Notable pickups in investment, trade, and industrial production, coupled with strengthening business and consumer confidence, are supporting the recovery. With growth outcomes in the first half of 2017 generally stronger than expected, upward revisions to growth are broad based, including for the euro area, Japan, China, emerging Europe, and Russia. These more than offset downward revisions for the US, UK, and India.”
Another potentially positive element is the prospect of tax cuts in the US. Equity markets had risen strongly after President Trump’s election last year on expectations of a strong fiscal boost – what has been called “the Trump trade” or “the reflation trade” – but had been subsequently disappointed by political dysfunction, which had prevented tax policy changes. Senate's passage of a budget bill on October 19 appears to have made a tax reform bill substantially more likely, and a reinvigorated Trump trade appears to be one element in the recent strong run for global equities.
Fund managers are also increasingly of the view that the global economy is firming. In the latest fund manager survey by Bank of America Merrill Lynch (BAML) in October, the proportion expecting above-trend growth exceeded the proportion expecting below-trend growth for the first time since 2011. As a result, a net 45% of fund managers are now overweight in equities, the highest level in six months.
Valuations Still High in America
But there are still two significant challenges to further strong equity performance.
The first is valuations, which are high by historical standards, especially in the US. Fund managers at BAML have responded with increasing the balance of investments in other parts of the world, particularly the eurozone, where a net 58% of managers were overweight in October, but also emerging markets and Japan. They have stayed underweight in the US and, because of Brexit risks, in the UK.
The second challenge is underappreciated risk. The fund managers can see potential upsets down the track – their top three were monetary policy mistakes by the Fed or ECB, North Korea, and a bond market crash – and so can the IMF. Its list also included monetary policy missteps but added other financial sector stresses, for example, the fragile state of some eurozone banks, protectionism, deflation, and geopolitical risks.
The fund managers were taking some modest steps to recognise the risks: they are on balance overweight in cash, but the actual cash level in the average portfolio of 4.7% is not especially high. Other measures, however, suggest that investors as a whole appear to be paying little mind to any of these risks materialising: measures such as the VIX index of expected volatility in US share prices, for example, continue to track at levels consistent with totally unruffled investors.
Cautiously successful normalisation of monetary policy and an improving economic outlook still look like the most probable scenario, and equities should make further gains if it comes to hand. But current valuations and investor complacency leave little room for error if something goes wrong.
