Strong corporate profits, valuations in line with historic averages and low inflation mean global equities remain attractive investments as the bull run continues, says T. Rowe Price’s Laurence Taylor.
The continued rise of global equity markets has confounded many investors who have become wary of toppy valuations in some parts of the world.
As the below chart shows, the MSCI World index has risen by 10.03 per cent in sterling terms, so far this year. Over 10 years – since around the onset of the global financial crisis – the index has risen by 130.53 per cent.
Performance of MSCI World YTD
Source: FE Analytics
Portfolio strategist Taylor said the asset management firm remains “gently optimistic” on the prospects for global equity markets.
He said: “While we believe we are witnessing a period of powerful secular change with broad consequences for investors, as with any phase of the market cycle, it is important to focus on fundamental, bottom-up research to unearth the best and most promising stocks.
“Complacency in any environment is risky, especially as valuations rise, so we are constantly evaluating our opinions and the risk/reward profile of our holdings.”
He added: “Encouragingly, we continue to see many opportunities in today’s market, even despite the gains equity investors have enjoyed so far in what has been one of the longest equity bull markets in history.”
One of the reasons for its ‘gently optimistic’ outlook is rising corporate earnings in many parts of the world, Taylor said.
“Global growth has been modest but trending upwards, and the political backdrop – North Korea aside – has been less extreme in nature versus worst-case scenarios,” he said.
“Most important, corporate earnings have been trending upward and broadly so, acting as a fundamental underpin to rising investor expectations.”
The portfolio strategist said bull markets tend to end due to crisis, as in 2007, or due to valuation extremes as was seen in 2000.
However, while some segments of the market have begun trading at premium valuations, Taylor said there was not the broad-based valuation extremes seen in the market in previous cycles.
Indeed, Taylor said while price/earnings (P/E) ratios were trading at around 10-15 per cent higher than 2007 highs, they were still only around 20-year averages.
Developed vs emerging markets, 12mths forward P/E ratio 1996-2017
“In fact, most markets look to be slightly cheap when compared with long-term averages on cash-based valuation measures, while even the premium valuation of the S&P 500 looks consistent with periods in history when the US economy was growing with modest, positive inflation,” he explained.
“Indeed, how we’ve managed to get so deep into this bull market without valuation extremes forming is perhaps worth considering when evaluating what may be in store for equity investors.”
The portfolio strategist said very cheap valuations at the depth of the global financial crisis had provided an anchor for the majority of returns to date and extended the overall duration “of what has been a very pessimistic bull market on average”.
The policy response by central bankers to the financial crisis has also continued to stoke equity market returns, explained Taylor.
“Expensive alternatives to equities, led by government bonds, combined with QE assisting a period of improvement for the global economy – employment has been rising on a coordinated global basis – have left equities still looking attractive on both a fundamental momentum basis and relative to alternatives,” he said.
“Absent an inherently unpredictable ‘crisis’, the fundamental backdrop is therefore still solid when considering the potential for global equities to hold their ground or deliver more, albeit more modest, returns.”
More recently analysts and investors have begun to speculate whether the end of quantitative easing and tight monetary policy will provide the catalyst that ends the bull market, he said, particularly with leverage having increased broadly.
However, while rate hikes could create challenges for the global economy and global equity markets, the strategist said, inflationary trends of late 2016 and early 2017 have stalled, a positive sign for borrowers. He said it may defer and downplay credit issues related to “imprudent borrowing”.
CPI inflation over 10yrs
Source: OECD
“We believe the reasons why inflation is likely to remain subdued are broad-based, secular in nature, and have potentially wide-ranging consequences for investors,” he said.
“While there are material long-term implications if we are right, near term, the impact has been to adjust expectations around when interest rates may rise and by how much, with the consequence of adding more gentle fuel to the equity embers.”
Taylor noted the deflationary influences of disruptive technologies in unlocking capacity and demographics and the shrinking working-age population.
“Put together with globalisation—which has helped to grow global trade in total but has also remapped the share of individual countries’ contribution and compressed production prices—both of these forces are undoubtedly disinflationary,” he said.
Taylor said that, in past cycles, the influence of these deflationary factors was muted through an increase in sovereign borrowing and spending, and in inflationary conditions in natural resources production. However, sovereigns are now unable or unwilling to increase debt, while China’s demand for natural resources has waned.
“What does this mean for global equity investors?,” said Taylor. “One natural conclusion is to own those stocks on the right side of the changes we are seeing today, the disruptors taking market share from rivals.
“This has been a profitable exercise in recent years and, at the right price, will continue to be a source of opportunity for forward-looking investors.”
He said segments defined by change and disruption, particularly in the consumer discretionary and technology sectors, lend themselves to active management over those where change is less dramatic, such as companies in the consumer staples, utilities, or telecommunications sectors.
Taylor added: “Being active, being nimble, and being open to change will be important if disruption continues or if the disruptors become a bubble in themselves.”