This is the first year since 2007 that all 35 OECD countries are growing but concerns remain over the US and China. Market corrections could be just around the corner, writes Charlotte Moore.
Global growth is in a Goldilocks zone: expansion is just enough to provide economic stimulus but not too much to raise concerns over inflation. Investors should make the most of this benign environment but pay careful attention to relative values and be wary of market corrections.
This is a period of unusual stability in terms of both the level and depth of growth, says J.P. Morgan Asset Management multi-asset market strategist Mark Richards.
Typically, there is a pattern of investment analysts starting the year with an optimistic outlook and then trimming those forecasts over the course of the next 12 months. But this year has been different.
Richards says: "This is the first year in at least seven years this optimism has been realised." The initial estimates for the corporate earnings growth for MSCI's all-country world index were 13% but these have been revised up.
Richards adds: "There have been similar upward revisions for economic forecasts." According to Bloomberg, consensus euro area gross domestic product (GDP) growth for 2017 has risen from 1.4% to 2.0%.
Janus Henderson Investors head of multi-asset Paul O'Connor says: "This is the first year since 2007 that all of the 35 member countries of the Organisation for Economic Co-operation and Development are growing."
Over this last year, not only has the outlook become more stable, but it has also become more balanced. European growth has rapidly recovered, surprising both analysts and economists. Earnings growth in Europe is expected to be 11% this year, after five or six years of downgrades.
"This is the first year that investment analysts have had to edge up their expectations rather than down," says O'Connor.
Schroders chief economist Keith Wade adds: "Not only did we revise up the last two quarters, we may have to revise up our forecasts again." European business surveys remain robust while there is little sign that the strength of euro is having a negative impact.
Such is the strength of the European recovery that Schroders expects growth to slightly outstrip that of the US. "It's been many years since that has happened," says Wade.
Economic growth in Europe is being driven by a pick-up in consumer spending. "The recovery of the banking system been an important driver," says Wade.
Bluebay Asset Management head of credit strategy David Riley agrees: "Access to credit for both European corporates and consumers is improving."
The pick-up in global trade has also benefited Europe. While the European economy is relatively closed - exports are only around 10% to 12% of Europe's GDP - global trade is still surprisingly beneficial for the region.
Even though the level of global exports is fairly low, it can bolster the growth rate. Wade says: "Stronger trade effectively helps to leverage up the overall growth rate."
The peripheral economies of Europe have also started to recover. "After a long period of austerity and reshaping of its banking sector, Spain's economic growth has started to pick up," says Wade.
Emerging markets are also performing better than had been anticipated. Wade says: "This reflects China's economy not cooling as rapidly as investors had anticipated."
Riley adds: "China also appears to be successfully managing to reduce the debt burdens in parts of the corporate sectors without deviating too much from its growth path."
The fundamentals in the emerging market economies have also improved. Riley says: "These markets have weathered two major shocks - the taper tantrum in 2013 and the slowdown in China and resultant fall in commodity prices."
Russia and Brazil have emerged from recession, which has resulted in their currencies remaining stable. Wade says: "Central bankers have cut interest rates as inflation falls in those countries."
Principal Global Investors global investment strategist Seema Shah cautions: "The outlook could change for the emerging markets, however, depending on the actions taken by the US Federal Reserve and movements in commodity pricing."
Also, while China does seem to have a good job of walking the tightrope between letting growth run while pulling back on excessive debt levels, it might not be able to maintain this feat.
State Street Global Advisors EMEA head of strategy & research Altaf Kassam says: "There are concerns about how much debt there is outside of the banking system which could implode."
The US economy is still growing but momentum has peaked. Businesses are, however, starting to spend again on capital expenditure. Wade says: "This has been at very low levels for most of the recovery after the financial crisis."
While this is positive news, it is not yet clear whether this is a long-term trend. Wade says: "This is often a lagging indicator - businesses invest once the economy has started to grow."
But the very low level of inflation in the US is a potential concern. "This could indicate there is secular stagnation, especially as real income growth has been weak." he adds.
The other concern is the sustainability of consumer spending in the US, which contributes around 70% to GDP. Wade says: "The US has been dependent on savings ratios falling and borrowing levels increasing to sustain consumption."
Consumer spending has started to moderate. "If spending starts to match real income trends then it will weaken over the next year," he adds. If consumer spending weakens, then this might put the brakes on further capital investment, he adds.
Despite these concerns, the overall outlook is benign. Shah says: "Economic expansion is happening smoothly because no one region is growing very rapidly."
Riley adds: "It's been a long time since there has been a broad-based, synchronised global economic upturn."
This prevents inflation pressures from building, which allows central banks to return to a more normalised interest rate environment at a very gradual speed. Shah says: "This helps to prolong this positive economic cycle."
Valuations are tight
The greater risk for investors comes from the mismatch between economic growth and financial markets. While the economic growth looks benign over the medium term, financial markets paint a different picture.
Valuations are at, or close to, peak levels across equity and credit markets, which is usually a clear signal that the next market move will be a correction.
Shah says: "The only way to interpret these different signals from the economy and financial markets is that conditions need to be perfect for this benign situation to continue."
In other words, central banks need to continue to move slowly, geopolitical tensions should not come to fruition, the value of the dollar should remain steady and oil prices should remain at around $40 (£30.20) to $50 a barrel.
It is, however, a fine balance. Shah says: "Valuations are so tight that if there is any negative reaction either to political risk or monetary tightening, it could create a drop in confidence which would feed through to the economy."
And that impact will be on the global economy rather than just one region because the world is now so interconnected. Shah says: "The feedback effect cannot exaggerated." If US 10-year treasuries start to sell off then bunds will mirror that movement.
But a focus on valuations does not give the whole picture. Richards says: "Rather than focusing on price-to-earnings ratios, we have started to look more closely at companies' ability to generate free cash flow."
The low inflation and low-wage growth environment has been beneficial to many companies. Richards says: "Margins have held up much better than expected, which has resulted in major equity markets offering fairly attractive free cash flow yields of 5% to 5.5%."
This underpinning of strong cash flow fundamentals indicates it is still worth owning risky assets. Relative value also plays a role. Kassam says: "While it would be impossible to call equities cheap; they are still better value than bonds."
Shah adds: "Investors should instead be looking to rebalance their equity portfolios away from US and increase weightings towards Europe and the emerging markets."
Rather than reducing weightings to risky assets, many investors are instead turning to insurance. Kassam says: "While we struggle to understand why implied volatility is at such low levels given the current geopolitical risks, we are taking advantage of it."
He adds: "We have protected our various absolute return portfolios with put spreads." Not only are asset managers putting this type of protection in place, so too are institutional investors.
"We have had more requests this year for options protection than there has been for several years," says Kassam. The demands have come from third-party distributors to whom SSGA sells white-labelled funds as well as underfunded pension funds and sovereign wealth funds.
In previous years people were talking about using this kind of protection but this year they have started to execute these trades, he adds.
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