Global equities pulled back in February, with the MSCI All-Country Index dropping 3.5%, largely due to concerns over rising inflation and bond yields in the US, following a higher than expected US wage gain reported for January.
By region, declines were fairly evenly spread across the US, Europe, Japan and Emerging Markets. By contrast, Australia’s S&P/ASX 200 Index held up reasonably well, delivering a 0.6% gain.
Rising bond yields are pressuring valuations, while earnings still look solid
The decline in stock prices last month did not reflect any near-term concerns with regard to the earnings outlook. Indeed, helped by optimism flowing from US tax cuts, global earnings expectations continued to be revised up last month, and imply growth in forward earnings of a further 7.5% by end-2018, and further growth of 9% in 2019.
Instead, it was the spike higher in interest rates that did the damage, with the yield on the Bloomberg Global Aggregate Bond Index rising 21bps to 1.9%, which helped drag down the price-to-forward earnings ratio for the MSCI-All Country Equity Index from 16.1 to 15.5. The market’s equity-to-bond yield differential ticked up slightly to 4.6% – which is still broadly in line with its longer-run average (i.e since 2003).
So what’s the outlook? At face value, the fact equity prices declined in February is not an immediate cause for concern. As we’ve noted in recent months, from a purely technical perspective, a pull back has been overdue given several months of very solid gains. What’s more, the earnings outlook remains strong and although the market’s overall PE ratio remains at above average levels, valuations relative to bond yields don’t appear overly stretched. And after an initial sharp sell-off, equities have staged a comeback in recent weeks.
In this light, the key issue going forward is whether US inflation (and hence bond yields) is truly breaking out in a way that could slow economic growth and earnings and/or seriously pressure PE valuations. While this remains a risk, my base case remains that the lift in US wage inflation (and especially consumer price inflation) is likely to remain relatively moderate – due to global competitive pressures – such that US 10-year bond yields should end the year at not more than 3.25% (from around 2.9% at present). And while this should cause global PE valuations to ease somewhat, this is likely to be more than offset by growth in forward earnings, such that overall equity prices should still end the year higher than where they are now.
That said, a new source of potential volatility at the time of writing is US President Trump’s lurch toward protectionism. While a tit-for-tat escalation in trade restrictions could be very damaging for both business and investor confidence, chances are that Trump’s bark will (as is the case so far with North Korea), prove worse than his bite. If Trump announces only token steel tariff increases limited to only a few small countries – without widespread trade retaliation from major economies such as Europe and China – chances are that global markets will once again be able to shrug off his latest erratic act.
Sector/Regional Themes: Technology, Resources and Japan
Among our key sector and regional exchange traded funds, our non-currency hedged NASDAQ-100 ETF (NDQ) produced the best return of 2.5% in February. That reflected a relatively modest (1.2%) decline in the NASDAQ-100 Index in $US terms, being more than offset by a 3.6% decline in the $A versus the $US. Our local financial sector ETF (QFN) also held up reasonably well, while returns for the Resources ETF (QRE) also fell by only a relatively modest 0.7%.
Based on a momentum ranking (an average of three and six-month return performance), the top-ranked performers at end-February were NDQ, our Australian Resources Sector ETF (QRE) and our Global Banks ETF (Currency Hedged) (BNKS). Indeed, as noted above, the NASDAQ-100 held up reasonably well in last month’s risk-off environment, and is consistent with global technology remaining an important lead sector in the current bull market. QRE has performed especially strongly over the more recent six month period, reflecting commodity price optimism, given synchronised global growth. BNKS is also benefiting from rising global interest rates, as this tends to boost the profitability of financial companies.