Market Comment 12/10/2017
A Brighter Forecast for Equities?
It is becoming increasingly apparent that the usual summer manufacturing lull has been less deep than normal, distribution channels are short of inventory and end demand across most regions and sectors is not disappointing. This points to further positive earnings surprises to come.
The more robust demand picture has led to increases in industrial commodity prices (such as aluminium, copper, iron ore and oil), and so throughout the value chain from raw materials to end products, costs are beginning to rise.
The picture painted encapsulates neatly the dilemma that fund managers are facing, namely that healthy economic demand is leading to earnings upgrades but that this is also tightening demand and supply balances such that price rises are likely to become more prevalent across a variety of sectors. As evidence of this mounts, it is likely to galvanise central banks into action.
The reversal of quantitative easing alongside interest rate rises could mean the period of excessively cheap financing is on its way out. If this is the case, it could push some weaker over-indebted companies into bankruptcy. The recent filing for bankruptcy protection by Toys ‘R’ Us in the United States may well be a forewarning of what is ahead. The consequence of this would be an earlier than expected turn in the credit cycle as banks become more wary to whom they lend. Furthermore, this dynamic has the potential to derail the stellar increase of asset prices since the dark days of 2009.
A core belief of fund managers seems to be that inflation in advanced economies is dead and buried. The current group think has, in our view, become too extreme and many investors may be surprised how fast inflation returns to the global economy over the next year or so.
Given the improved demand position we are more comfortable with our equity (and high yield corporate debt) positioning than we have been for some time...
If we are right on this and medium term inflation expectations start to rise, investors could be underestimating the potential scale of interest rate rises that are ahead of us. We, therefore, continue to avoid longer dated government debt which we believe could sell off sharply in such an environment.
Given the improved demand position we are more comfortable with our equity (and high yield corporate debt) positioning than we have been for some time, although it should be noted that we are long overdue a pullback in equity markets.
We believe the US Dollar is oversold and that it is likely to rally as the Federal Reserve continues to increase interest rates. This will dampen sentiment towards emerging market equities, which have produced good returns year to date. The acceleration in global economic activity will benefit the Japanese stock market disproportionately as economically sensitive exporters are well represented on the listed market and corporate governance reform is really beginning to take hold in Japan.
We have added risk, at the margin, to reflect our improved confidence in the near term outlook for equities.
In summary, we think the near term outlook for earnings growth (and, by extension, equity markets) has certainly improved. We have added risk, at the margin, to reflect our improved confidence in the near term outlook for equities. However, the medium term consequences of the better demand picture could yet be negative for equity and debt prices. However these late cycle risks will not become evident for a while yet and so we believe investors will take heart and may well push stock markets higher in the interim.
Chief Investment Officer