In synch—that may be one way to sum up 2017. From synchronized global growth among the world’s major economies to soaring equity markets in Europe, Asia and the U.S., the world seemed to shift into a higher gear during the past year. Here’s a look at some of the forces that drove the global economy and the world’s markets.
Global Economy and Markets Gain Momentum
The global economy hasn’t exactly set any new speed records so far in 2017, but it has picked up the pace. The International Monetary Fund said in its flagship report, known as the World Economic Outlook, that an upswing was under way across nearly all the world’s major economies. The IMF also raised its forecast for growth this year to 3.6% and 3.7% next year, an acceleration from the 3.2% growth recorded in 2016.
Global equity markets have also risen this year as strengthening economic data in the U.S., Europe and Japan boosted investor sentiment. Japan’s Nikkei Stock Average hit a two-decade high in October. The U.S. economy has continued to expand at a modest but improving tempo, and there were reassuring signs that growth may finally be returning to Europe after nearly a decade of fits and starts. The economic and political implications of the United Kingdom’s decision to leave the European Union continue to reverberate, but British stocks have climbed despite the volatility.
Against that background of improving global growth, the economies of many emerging markets have continued to show renewed strength. Brazil and Russia, for example, have been expanding after several years of contraction. At the same time, government stimulus appears to have steadied growth in China, which remains a critical component of the global outlook.
Into Thin Air: U.S. Equity Markets at Lofty Levels
When record highs become routine, attention must be paid.
By the middle of October, for example, the Dow Jones Industrial Average had logged 47 record finishes for 2017. The Standard & Poor’s 500 Composite Index, well into the ninth year of a bull market, set 43 new highs this year. The S&P 500 has also delivered a total-return gain for every month through September — something that has happened only once before, in 1995. Not to be outdone, the Nasdaq Composite also repeatedly set record highs in 2017.
As a result, U.S. equities are relatively expensive. Granted, higher valuations can be justified by a number of factors, including economic tailwinds. Although still not in top gear, the U.S. economy is improving. Employment and manufacturing data have been relatively strong this year, and business and consumer confidence measures also have been high.
In addition, corporate profits, which came under pressure in 2015 and 2016, have rebounded. Indeed, S&P 500 companies posted two consecutive quarters of double-digit profit growth during the past year for the first time since 2011. The strong corporate earnings growth has spurred investor optimism, and certainly contributed to the record highs.
But market capitalization levels around the world show the U.S. at a nearly all-time high while overseas markets remain relatively low. The outlook for European markets has markedly improved. China is stabilizing and emerging markets are rallying. Given the valuation gap between the U.S. and everywhere else, it may be time to consider rebalancing portfolios toward non-U.S. markets.
The Wind Is Back in Europe’s Sails
Europe may have reached a turning point in 2017, both economically and politically.
Granted, Europe’s economic recovery hasn’t exactly been sizzling. But data points are increasingly indicating that Europe is in a healthier economic state than it has been for more than a decade, and that a base may be building for a period of prolonged strength. Indeed, the wind may be back in Europe’s sails, with the 19-country European Monetary Union expected to grow nearly 2% in 2018 — still relatively modest but stable.
Emmanuel Macron's presidential victory in France on a business-friendly and pro-European Union platform seems to signal a political shift in Europe. While Macron’s triumph seemed to indicate centrist politicians were beating back a populist backlash, the German election somewhat darkened the mood. In Germany, Angela Merkel won a fourth term as chancellor, but the strong showing of an extremist nationalist party served as a reminder that Europe’s politics remain volatile.
If Europe seems to be bouncing back after a tough decade, the region still faces risks, including high unemployment in some countries and ongoing uncertainties over the United Kingdom’s decision to leave the EU. Those issues, however, have also restrained the share price of some companies, and valuations of select companies in Europe appear relatively attractive. Although the large valuation gaps between U.S. and European firms have been narrowing in recent months, there are still select investment opportunities.
Indeed, the economy and companies are likely to benefit from a weaker U.S. dollar, continued central bank stimulus measures and ultra-low interest rates, all of which could provide a favorable environment for economic growth and potential reward for investors.
Soaring Emerging Markets Are on a Long Runway
Stocks and bonds in developing countries have been surging in 2017, with the MSCI Emerging Markets Investable Markets Index advancing 27.1% through the third quarter. The bond markets, as represented by the J.P. Morgan Emerging Markets Bond Index Global Diversified, recorded a return of 9% over the same period. This index measures broad returns across U.S. dollar-denominated emerging markets bonds.
Such outsized gains can give investors pause, but keep in mind that developing countries around the world are on a long runway. Now, with a background of improving global growth and potentially higher export volumes, the rally may have room to run.
Indeed, the political and financial systems in many developing countries have come of age during the past two decades, providing greater societal stability and economic resilience. Fueled by these favorable trends, emerging market economies are rapidly increasing their share of global growth and are expected to contribute half the global GDP by 2021.
Several developments add weight to the case for investing in emerging markets. One is the now well-documented evolution of a middle class, with millions of people moving into the middle class and creating a consumer class with discretionary income.
This remarkable demographic and economic transition has now entered a new phase, one that’s likely to shift the demand for goods and services from basics such as diapers and detergent to the finer things in life. Millions of people around the world are moving into the upper-middle class, and even the upper class. By the end of the decade, about 440 million people are expected to achieve these income levels in Brazil, Russia and China alone, according to data from Euromonitor International. The rising affluence in developing countries should be a durable trend that it is likely to continue for many decades, and underpin investment returns.
The other trend is a relatively new phenomenon—the emergence of multinational companies. In 2000, for example, there were only 20 companies on the Fortune Global 500 list based in developing countries. Now, there are 150, including China’s Alibaba Group and Tencent Holdings. In all, emerging economies are home to thousands of multinationals. In nearly every industry, these companies are playing an increasingly important role, and some of them are taking their place among the most powerful companies in the world.
Rates Rose in 2017, but Don’t Bail on Bonds
The U.S. Federal Reserve has raised rates twice in 2017, to a range between 1 and 1.25%, and may do so again in December. The Fed has also announced the start of a gradual shrinking of its $4.5 trillion balance sheet, which was swollen by massive purchases of Treasury bonds and mortgage-backed securities in the aftermath of the 2007-2009 financial crisis and recession.
All of which has made bond investors nervous. But the Fed’s moves have been well telegraphed, and that may make all the difference. History shows that as long as hikes don’t catch the market by surprise, such as the hikes that began in 1994, they can have a relatively modest impact on long-term yields.
Even if rates rise more than expected, as long as they rise gradually, bonds may be able to absorb the associated price declines. That’s because price changes are only part of bond returns. Income is the other critical component, and when interest rates rise, the portfolio’s income can increase. In short, price declines can be moderated by interest income. Moreover, as lower yield bonds mature, investment professionals can take advantage of higher rates when redeploying the proceeds by investing in bonds with a higher yield.
Bonds play a variety of roles in a diversified portfolio, including providing income and capital preservation. They also help mitigate volatility. When equities get volatile, bonds typically perform better and provide balance to a portfolio. The rate increases now underway should not change that fundamental relationship.