Chief Investment Strategist
April 20, 2018
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We expect the 20%+ EPS gains reported from large cap US firms in Q1 to raise confidence
Financial markets have moved quickly to price in an increased probability of economic disruption from trade disputes, leading a contraction of equity valuations. While US monetary policy tightening remains an ongoing risk, we expect corporate earnings to make strong gains.
Equity markets likely have underrated the path of economic growth over the year ahead. As such, the Citi Private Bank Global Investment Committee on 18 April left in place its asset allocation of 4% to Global Equities (with US equities at a full or neutral allocation). Global Fixed Income remains underweight by 4%.
Policy uncertainty over US tariff plans has continued to sideline global equities markets following strong gains in the year through January. The risk of outright economic disruption from a broadening, US-led trade war is a modest, but legitimate risk. The impact on corporate profits of affected companies (from supply-chain disruptions or lost sales) is of a much greater magnitude than measures of GDP impact, in our view.
Nonetheless, the many country exemptions to US steel and aluminium tariffs, solid reports of progress on North American Free Trade Agreement negotiations, and dialogue between the US and China suggests worst-case scenarios for global trade are unlikely. Against this backdrop, the restraint in global share prices has left forward-looking valuations attractive over our 12-18-month tactical return period.
On reasonable expectations of earnings per share (ESP) gains this year, the forward valuation of US shares has fallen to 16.5X operating EPS and 13.5X for non-US shares. This offers a solid return outlook even considering ‘late cycle’ economic conditions in the US. (US unemployment has fallen to historically low levels and US corporate profits are above estimates of their long-term trend).
We expect the 20% EPS gains reported from large cap US firms in the first quarter (including the tax cut impact) to raise confidence in strong earnings estimates for the full year 2018. Meanwhile, EPS gains of about 15% outside the US should more than offset a likely valuation contraction globally.
EPS gains are likely to persist into 2019 at a minimum, and we see overall global equities returning about 8% in US dollars in 2018. Most profit margins outside the US don’t appear at risk of peaking. While EPS gains present a strong base case and outweigh our worries over rising interest rates, there are many local political risks impacting the various international markets that we overweight.
Similarly, there are many policy and political risks that could impact the US. We continue to look for regional diversification to significantly offset these idiosyncratic risks when measured over a year or more and advocate ‘fully global’ equity portfolios. In fixed income, we remain overweight short-dated US bonds (and investment grade debt overall) given high US yields relative to other developed markets and US cash. However, foreign exchange hedging costs may make US dollar bonds less appealing to certain global investors.
Though return opportunities have diminished some after strong rallies in 2016-2017, emerging markets fixed income remains a compelling asset class. Global high yield bonds have also posted positive returns in the year-to-date, as have variable rate loans.
As noted, last month we reduced the scope of our overweight in US high yield to take advantage of both higher absolute yields on investment grade issues and to exploit the benefits of a lower correlation between high grade bonds and equities. This reduces overall portfolio volatility while only minimally impacting expected returns. We continue to see an asset allocation that holds high quality bonds with positive yields as best able to take advantage of the stronger returns in higher-risk equities, at a given risk level. This is best measured by risk-adjusted returns for multi-asset class portfolios relative to single asset class portfolios.