- Innovation and disruptive change continue to benefit a relatively small group of mega-cap companies. Despite recent gains, valuations for these stocks still appear reasonable.
- For the first time since the global financial crisis, the world economy is in a synchronized expansion, driving steady earnings growth in most markets.
- Barring unpredictable political or economic shocks, the global earnings recovery should continue in 2018. However, year-over-year comparisons will grow more challenging.
- Whether recent low market volatility persists in 2018 remains to be seen, but we do not believe low volatility in itself predicts that a significant correction is imminent.
Moving into 2018, we expect to see a further acceleration in the disruptive forces being unleashed in global equity markets by a powerful combination of technological innovation, changing consumer preferences, and evolving business models. These forces are upsetting the competitive balance in existing industries, while at the same time spurring rapid growth for new products and services.
This wave of change should continue to benefit a small group of mega-cap companies that have created dominant technology platforms in industries such as e-commerce, social media, mobile devices, and Internet search. Key advantages, including large user bases, massive computing power, skilled workforces, and ample financial resources, have allowed these companies to leverage powerful economies of scale, sustaining rates of growth that are almost unprecedented, given their current size.
In our view, the valuation multiples currently awarded to some of these stocks are justified by their growth potential—although we recognize the need to differentiate between companies with high current cash flow and earnings and those that are largely reinvesting in their businesses. Looking ahead, we see two key trends worth watching in 2018:
- The scope of disruption is expanding. While retail, advertising, and consumer electronics have been the most visible arenas for disruption so far, advances in genetic mapping are driving the development of new drugs, while horizontal drilling technology has pushed global oil prices sharply lower. Technologies such as electric vehicles and autonomous driving suggest that the transportation industries could be next in line for rapid transformation.
- Political attitudes are changing: Until recently, the technology giants have been widely admired for the benefits—selection, convenience, low prices—they have delivered to consumers. However, data privacy and security concerns, and controversies about social media’s role in recent elections, have raised questions about corporate governance and how these firms wield their economic power. This creates the potential for a regulatory backlash.
We believe opportunities for profitable growth—both organically and through acquisitions—will remain plentiful for these winners as they extend their brand power and distributional control across markets and geographic regions. However, the political climate for them will bear watching in 2018.
For the first time since the 2008–2009 financial crisis, the global economy appears to have entered a synchronized expansion. Strong growth, ample liquidity, and low inflation have produced an extended period of exceptionally low volatility—not just in global equity markets, but in credit and currency markets as well. While it remains to be seen whether this period of calm will persist in 2018, we would not necessarily view it as forecasting a correction to come. T. Rowe Price’s research suggests that periods of low market volatility can resolve themselves to either the upside or the downside.
Similarly, valuation multiples that are above historical averages in most developed markets do not necessarily mean that global equities are overvalued. In the context of low interest rates and low inflation, equity risk premiums in many markets still appear reasonable, in our view.
Going forward, a key question will be whether strong growth and tightening labor markets will generate typical late-cycle inflationary pressures, forcing the major central banks into a more aggressive withdrawal of monetary stimulus. Current market expectations are for a continued gradual pace of Federal Reserve tightening and for the European Central Bank to begin a moderate tapering of its bond purchases in 2018. The Bank of Japan (BoJ) still appears committed to its own version of quantitative easing. These policies would be constructive for equities, in our view. However, considering the potential for faster growth and tighter labor markets, we are mindful of the risk of upside inflation surprises.
To a large extent, equity strength in 2017 reflected a broad-based recovery from the global profits recession that began in the second half of 2014 (Figure 1). In Europe, earnings revisions turned positive for the first time since 2012. Earnings momentum in the U.S. also appeared to reaccelerate. Meanwhile, Japanese companies generally did well despite a steady-to-stronger yen.
FIGURE 1: Synchronized Global Growth Boosts the Earnings Recovery
Earnings Per Share Growth In Local Currency Terms, Through October 31, 2017
Sources: FactSet, Standard & Poor’s, MSCI; data analysis by T. Rowe Price.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
Faster-than-expected growth in China—despite tighter money and credit as Beijing addresses the country’s bad debt problems—was in many ways the economic surprise of 2017. With China acting as the locomotive for the Asian economies, the broader earnings recovery in the emerging markets also accelerated.
Barring unpredictable political or economic shocks, we expect the global earnings recovery to continue in 2018; however, year-over-year growth comparisons will become more challenging. We believe markets will weather slowing earnings momentum as long as investors perceive the underlying growth trends are positive and can be sustained as the economic cycle continues to mature.
U.S. Tax Reform
As tax reform legislation moved swiftly through Congress in late 2017, it appeared many multinational firms were evaluating how a revamped U.S. corporate tax code could impact their businesses. In addition to boosting after-tax reported earnings, we believe meaningful rate cuts could spur capital spending and hiring, potentially giving a second wind to earnings growth.
In terms of economic sector performance, much still depends on whether U.S. fiscal stimulus leads to a further acceleration in the global economy in 2018. If so, the “reflation trade” favoring cyclical value could be revived, although rate-sensitive sectors such as real estate investment trusts, utilities, and consumer staples potentially would be challenged. On the other hand, if economic momentum slows, secular growth could regain favor.
Emerging markets generally outperformed through the first 10 months of 2017, while the ex-U.S. developed markets, as measured by Morgan Stanley Capital International’s Europe, Australasia, Far East (EAFE) Index, outperformed U.S. equities in U.S. dollar terms (Figure 2). Looking forward, our regional perspectives include:
- United States: After lagging secular growth stocks through much of 2017, cyclical sectors showed some strength in the second half, perhaps reflecting growing optimism about U.S. fiscal stimulus. U.S. corporate tax cuts would tend to favor U.S. small-caps, which are more exposed to the domestic economy and are more heavily taxed, on average, than their large-cap counterparts.
- Europe: Financials, energy, and materials are heavily weighted in the major European indexes, so higher interest rates, a steepening yield curve, and/or a more sustained recovery in commodity prices all would be constructive for earnings. While Catalonia’s separatism crisis is negative for Spanish equities, we see no contagion effect that might undermine confidence in Europe more broadly.
- UK: The exception to a generally positive European picture is the UK, where there are growing signs of financial stress—in the London property market, for example. The longer Brexit negotiations go on without meaningful progress, the more hiring and investment decisions are likely to be put on hold, increasing the risk of a downturn.
- Japan: Japanese equities historically have been highly sensitive to the global economic cycle. With the BoJ focused on managing the long end of the yield curve, a combination of strong export demand and a weaker yen potentially could be very supportive for equities. Continued corporate reform and a shift to more shareholder-friendly policies are additional positives.
- China: We continue to focus on China’s domestic technology titans, as recent equity performance has been even more concentrated in those names than it has in the U.S. market. However, structural reform of state-owned enterprises could create future opportunities in basic industries such as steel and coal.
- Other Emerging Markets: Lagging economies in Brazil and Russia have stabilized and asset prices have been strong. India was the one major negative surprise in 2017, as demonetization caused temporary shocks, aggravated by bad debt burdens. Recent moves to address the debt situation will help. We see potential pockets of vulnerability should the U.S. dollar strengthen in 2018, including Turkey and some Central and Eastern European markets. However, these issues are not significant enough to create broader systemic risks, in our view.
FIGURE 2: Emerging Market Equities Led in 2017 While the U.S. Lagged the Other Developed Markets
Cumulative Returns, December 31, 2016, Through October 31, 2017, In U.S. Dollars
Past performance is not a reliable indicator of future performance.
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