The outlook for equity markets for the rest of this year has become more challenging. For starters, investors will need to weigh up the implications of Brexit, recent banking stress tests, and the increased uncertainty over the timing and pace of Federal Reserve (Fed) rate hikes.
The common thread linking all these factors is uncertainty – which is to asset markets what a pin is to a balloon.
The UK’s decision to leave the European Union (EU) poses as many challenges for the euro area economy as it does for the UK. For this reason, we have downgraded our outlook for euro area equities to ‘cautious’ from ‘positive’ – and upgraded UK equities to ‘cautiously positive’ from ‘cautious’, reflecting the benefit of a weaker pound on internationally focused large UK corporates.
"The euro area’s challenges pre-date Brexit"
Banks have been at the forefront of the uncertainty created by the Brexit vote, compounded by the results of the European Banking Authority stress test. European-listed banks have under-performed those listed in the UK year to date, reflecting fears over the possibility of new capital raising and lower dividends in the coming quarters.
Lower policy rates are also a concern for UK banks following the Bank of England’s decision to cut rates and re-start quantitative easing.
The euro area’s challenges pre-date the Brexit vote. Lacklustre revenue growth and an appreciating euro were already weighing on the export sector, with consensus earnings growth for the euro area equity markets in 2016 forecast at a mere 1 per cent.
While consensus estimates still project a 12 per cent rise in euro area earnings in 2017, it is almost inevitable that they will come under downward pressure in light of recent events.
More confident in US earnings growth
The S&P500 has a similar pattern for consensus earnings: flat this year, rising to 14 per cent in 2017. However, we have greater confidence in the achievability of US earnings growth, as companies there are somewhat insulated from developments in the EU, and could actually be beneficiaries of increased domestic investment diverted from the EU.
Another factor supporting US earnings growth in 2017 is the recovery in energy sector profits – not just from higher oil prices, but also the dramatic decline in asset write-downs related to the prior collapse in oil prices.
Corporate investment tends to thrive in an environment of growth and certainty, both of which are in short supply in Europe currently. Companies in the transportation and communications sector have already announced reviews of future investment in light of Brexit. Such news will be received negatively by investors and policy makers alike.
Slower investment will impact future profit growth and could also weigh on economic growth in the coming quarters. Already this has prompted the Bank of England to cut rates and re-start quantitative easing. It could also lead the Fed to think twice before raising rates.
While lower-for-longer US rates would have positive implications for high dividend yielding equities and fixed income markets, it reinforces our concern over the outlook for earnings growth and is a factor in our decision to reduce our allocation to equities since the start of this year.
Given all of this, what options do investors have?
"Multi-income strategies rank highest in order of preference amongst the key asset classes"
We continue to emphasise the importance of multi-income strategies, which rank highest in order of preference amongst the key asset classes. We also believe that alternative strategies and fixed income, specifically developed market corporate bonds and emerging market US dollar government bonds, should feature prominently in investor allocations. Meanwhile, equities, commodities and cash rank in the lower half of our asset class preferences.
While we have reduced our allocation to equities as an asset class, high dividend-yielding equities are attracting renewed interest in light of the fluctuating expectations for rate hikes by the Fed. There is also renewed interest in emerging markets, buoyed by the recovery in commodity prices from prior lows and selectively high dividend yields. Indeed, within equities, we have the highest preference for Asia ex-Japan stocks, which rank slightly above US equities.
Asia recovery offers compelling opportunities
Earnings revisions have started to recover in Asia as analysts have become more positive on the outlook for domestic demand following the easing of monetary policies across many markets in the region. With valuations now more attractive than earlier compared to developed markets and non-Asia emerging markets, we expect a recovery in portfolio flows leading to performance in Asia ex-Japan playing catch up with that in non-Asia emerging markets.
Uncertainty looks set to remain a feature of asset markets for the rest of the year. Nevertheless, there remain opportunities for those who adapt their investment strategies. In particular, investors will need to keep a close eye on several upcoming political events, including the Brexit talks, the Italian referendum in October and the US Presidential election in November.