For financial markets, the start of 2017 couldn’t have been more different to last year. Donald Trump’s election in the US appears to have revived ‘animal spirits’ in the world’s largest economy, and business confidence is once again on the rise here and elsewhere.
US economic growth is likely to accelerate above 2 per cent, while Asia ex-Japan is likely to remain the biggest contributor to growth in 2017, with market consensus forecasting 5.7 per cent expansion in 2017.
The global inflation outlook, meanwhile, remains relatively benign due to sufficient spare capacity worldwide, despite tightening labour markets. This backdrop should result in two or three Federal Reserve (Fed) rate hikes between now and the end of 2017, something the markets have already factored in.
However, the positive outlook is not without risks. In particular, any protectionist or punitive trade measures adopted by President Trump’s administration could heighten uncertainty.
"We have become slightly more positive on equities"
Also, faster-than-expected US inflation, perhaps due to building wage pressures, leading the Fed hastening the pace of rate hikes could strengthen the US dollar and capital outflows from emerging markets.
Given this likely ‘pivot’ to reflation in the world economy, a traditional balanced allocation between bonds and equities should perform reasonably well, especially when combined with an allocation to global macro strategies and gold as a source of insurance. Within this balanced approach, however, we have become slightly more positive on equities and less so on bonds, relative to a year ago.
US earnings growth potential
The recovery in corporate earnings has made the biggest difference in expectations for this year. Consensus expectations suggest US earnings growth is likely to accelerate to 12 per cent in 2017 from -1 per cent in 2016. Importantly, earnings growth has broadened beyond the energy sector to include banks, technology and healthcare.
Europe, Japan and Asia ex-Japan are also expected to see faster earnings growth, with Asia ex-Japan earnings estimated to accelerate to 13 per cent from 3 per cent last year.
We have become more positive on US profit margins given expectations of re-acceleration in growth in 2017 as well as the prospect for lower taxes. Perhaps more significant is the prospect for a pick-up in inflation – historically there has been a positive link between US inflation and corporate margins.
"The US has a greater likelihood of retaining its premium valuation"
In the financial sector, the market expects higher interest rates to lift net interest margins and boost return-on-equity and valuations. Outside the US, margins remain lacklustre in the euro area, but have the potential to show some recovery in Japan thanks to the weak yen.
Finally, we would characterise valuations across global equity markets as elevated. The key to a market retaining its premium valuation is an upside surprise to earnings growth. On this score, the US has a greater likelihood of retaining its premium valuation given the earnings growth prospects.
Impact of Trump’s repatriation policy
Based on these perspectives, the US is our most preferred market. Additional support is likely to come from moves by Trump’s administration to encourage the repatriation of estimated USD2.3 trillion of US corporate profits held overseas. A significant proportion of any such repatriation is likely to be used by companies to boost dividends and increase share buybacks.
We also like Japanese equities on a currency-hedged basis. The sharp weakening of the yen as a result of the Bank of Japan’s policy of anchoring long-term yields should help Japanese corporate earnings surprise on the upside.
In Asia ex-Japan, sentiment deteriorated late last year as the US dollar moved sharply higher. This raised concerns that the region’s central banks will be forced to pursue less supportive monetary policies.
Assuming we are right and US dollar strength is limited, we believe Asia’s underlying fundamentals should ultimately show through. For the time being, we prefer Asia ex-Japan equities where earnings expectations are improving.