US Tax Reform Set to Extend Global Rally

Loomis Sayles' Craig Burelle expects strong growth in company earnings to continue into 2018, helped by the cut in US tax rates - good news for equity investors

External Writer 23 January, 2018 | 9:05AM
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Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Craig Burelle, macro strategies research analyst from Loomis Sayles, looks at the prospects for the world economy and equity markets.

Bull and bear markets

Strength in developed and emerging economies has contributed to higher global manufacturing, increased export volumes and a recovery in corporate profits globally. Our base case is for the constructive global growth environment to continue into 2018.

While an easing in economic growth cannot be ruled out after such a positive stream of data, our view is that such a slowdown would be temporary and unlikely to derail the broadly positive trends across assets in riskier markets.

Years of loose monetary policy have fostered an economic expansion across developed and emerging countries, but we believe most asset classes are prepared for a slow transition to higher interest rates. Bond yields are likely to head higher, but at a modest rate that is unlikely to impact equity valuations in the near term. Corporate earnings have accelerated globally and the recent US tax reform passage presents an additional upside catalyst to domestic equities.

Signs of inflationary pressure are appearing in developed economies, mainly in the US. We expect US inflation to reach, and remain, just above the Federal Reserve’s target of 2% in the second half of 2019. Given favourable global growth and healthy economic indicators, the Central Bank is likely to hike at least two or three times in 2018, continuing its established gradual pace.

While an additional hike may be justified if the economy accelerates faster than anticipated, we would see such developments as confirmation of a strong economy rather than cause for concern.

Emerging Market Inflation Set to Fall Further

Eurozone economic activity also picked up markedly in 2017, contributing to headline inflation of more than 1% for the first time since 2013, a sign of economic normalisation. Consensus expectations are for headline inflation to run near 1.5% from 2017 to 2019. Similarly in Japan, price increases are starting to stick while growth has also picked up.

Emerging market inflation has been trending lower for well over a decade and is expected to decline marginally in 2018. More specifically, Latin America inflation should be in line with the overall trend lower, but with activity in Asia robust, inflation there is expected to accelerate throughout 2018.

With companies posting the strongest growth in global earnings since 2011, we remain positive on global equities looking out at 2018. Earnings rose at a double-digit rate in most major equity markets in 2017, and a similar growth rate is anticipated for 2018. Better earnings are the direct result of stronger global GDP growth coupled with a recovery from the energy/commodity downturn of 2014 to 2015. Friendly central bank policies have also been a positive factor, supporting the moderate price-earnings multiple expansion seen in most global equity markets this year. US earnings growth will likely be further boosted in future years by tax reform.

Market Volatility Could Rise

The prospect of a lower and more globally competitive corporate tax structure in the US, coupled with the prospect of repatriated earnings, will provide a foundation for earnings-per-share growth well into double-digit levels.

The two primary risks to our equity market outlook are if the current trajectory of improved earnings growth is derailed, and/or an unexpected shift in the Fed’s loose monetary policy. Both developments would put downward pressure on equity valuations and impede earnings growth. Geopolitical developments could also present challenges.

We are optimistic about 2018, but recognise that volatility could increase. With valuations already reflecting expectations for the strong earnings trend to continue and meaningful benefits from tax reform, any related disappointments could weigh on sentiment.

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