Investor sentiment remains firmly bullish, specifically in relation to Trump’s tax proposals. However, failure to push through the healthcare bill reforms has undermined credibility in the government. Markets have already priced in tax cuts and infrastructure spending to stimulate the economy. Yet with the US budget deficit still high and resistance to policy reform strong, implementing change will be challenging and failure to achieve a positive outcome could see a reversal of the Trump rally. Sterling has stabilised somewhat, with a gain of 1% against the US dollar following a difficult 2016 as investors were unnerved following the Brexit vote. Speculative short positioning hit a new record, indicating that the currency is susceptible to a sharp rebound once positions unwind.
The IMF expects global growth to rebound from 3.1% in 2016 to 3.5% in 2017, led by the US which is projected to grow at 2.3%, from 1.6%, due to hope of fiscal stimulus following Trump’s election success. China is still seen as the fastest growing major country, although growth is seen falling to 6.6%. Historically, equity valuations remain very high, especially in the US where the Cape Shiller Price Earnings ratio (a valuation measure usually applied to the US S&P 500 equity market, defined as price divided by the average of ten years of earnings, adjusted for inflation) rose to 29x, a level only exceeded twice in history: once in 1929 and again between 1997 and 2002.
Inflation has been rising in recent months, largely as a result of the year on year change in oil prices, which is the major contributor. In the UK, consumer price inflation (CPI) rose to +2.3%, compared to +0.3% a year ago. In January, producer price inflation (PPI) reached the highest level since 2008, indicating that CPI has further to run. There could still be an impact from imported inflation as fixed prices on foreign goods increase due to weakness in sterling following Brexit. With little evidence of inflation feeding through to wages, it will be difficult to maintain it above the 2% target. We believe that the Bank of England is therefore likely to look through the transient effects of higher inflation when considering raising interest rates.
With the potential for rising US supply to offset the OPEC cuts, oil was weakened, implying a lower trajectory for inflation than previously expected by the market.Interest rate futures markets anticipate one rate hike in the UK by the end of 2018, with the rate rising to 0.75% in early 2020. In the US, the market expects rates to reach 1.25% by early next year. Even these expectations could prove too optimistic if inflation drops off as we anticipate.
With the earnings season over, we note that stocks which missed expectations have fallen considerably. Companies with a positive outlook have moved modestly higher. This outlines the polarisation of performance, symptomatic of a distorted market. For example, expectations in infrastructure and industrials are high and leave little room for disappointment. Interest rates are rising but this is a very gradual process. This supports equities and bonds which still offer much better income prospects than cash, although a selective approach is warranted.