Gains have been helped by speculation with investors increasing their borrowing to fund equity positions. With GDP slowing in the US and UK, Europe has taken the lead, with growth in the region outperforming other developed markets. China continues to perform robustly.
The Trump reflation thesis, which caused great interest in equity markets after the US election, now looks threatened. Lack of progress in implementing tax cuts and pushing through higher infrastructure spending led the International Monetary Fund (IMF) to cut its growth targets for the US. GDP is now expected to peak at 2.1% this year before dropping back to 1.7% in five years, casting doubt on Trump’s claims that 3% growth could be sustained.
In the short term, consumer price inflation (CPI) appears to have peaked. In both the US and Europe, the annual rate of inflation has been declining steadily since February. With the additional constraint of a weaker currency, UK CPI has been higher, having hit 2.9% in May. However, producer price inflation (PPI), which measures the price of goods bought by UK manufacturers and is typically a leading indicator in predicting CPI, peaked in January. Therefore we expect CPI to drift lower in the second half of the year. We believe the wider backdrop remains deflationary; weakness in oil is a highly visible symptom of this.
In the US, the fixed income yield curve has flattened over the quarter, meaning that the gap between short and long dated yields has narrowed, reflecting expected moves in future interest rates. Even though short term rates are rising, following two rate hikes this year, the prospect for a sustainable increase in rates in the long run is diminishing in our view. This action has pressured the financial sector. The effects of lower long-term margins on banks, the result of lower interest rates, are not yet factored in to valuations. There have been contradictory messages from the central banks, most notably the Bank of England (BoE) and the European Central Bank (ECB). Whilst some representatives have talked about withdrawing stimulus and normalising rates, we note that actions speak louder than words.
Technology has become the top performing sector, which has helped push the broader Standard & Poors (S&P) 500 index to new highs. It is notable that technology stocks now account for 14% of the index by market capitalisation but only 7% of the revenues. Valuations are beginning to look excessive in this area, with significant future growth largely priced in. We see opportunities elsewhere in the US for more defensively minded investors.
In the UK, following a positive outlook on the consumer sector at the start of the year, we recommend investors trim holdings where valuations look high compared to historic levels. With the savings ratio at a record low and rapid growth in unsecured debt, the outlook for consumer spending looks less certain and more vulnerable, especially in the light of the BoE’s recent move to tighten standards for bank lending. The real estate sector potentially offers value, given widespread discounts to Net Asset Value. Much negativity is priced into the Brexit negotiations but the upside of a weak pound will be of further interest to overseas investors which is likely to support valuations. This will support the investment case for international earners. Diversification outside the UK remains a credible strategy. Europe continues to outperform and in Japan we are seeing improvement in the export markets.