Global equities have resumed their upward trend, more than recovering their wobble in mid-August. Markets were up 1.0% in local currency terms last week and have also opened higher this morning.
There have been no major developments to trigger the latest gains. Rather, global equities just continue to benefit from the favourable macro backdrop which has now fuelled year-to-date returns of as much as 18.1% in local currency terms and 15.3% in sterling terms.
Strong earnings growth, very supportive monetary and fiscal policy and low bond yields are the key factors here. All of these look set to become less positive over coming months with growth slowing, QE being scaled back and bond yields heading higher.
However, this deterioration should be quite gradual. While a correction of 5% or more (as opposed to the 2-3% declines seen in May and August) remains overdue, the environment remains broadly constructive for further gains in equities, albeit much more moderate than of late.
Growth is now slowing, as the initial reopening boost fades in the face of continuing bottlenecks and the spread of the Delta variant. Indeed, US employment posted an unexpectedly small rise in August. However, business confidence remains at high levels and growth looks set to stay well above trend over coming months, even if it will be significantly below the pace seen over the spring and summer.
As for monetary policy, all the focus currently is on when the Fed will start ‘tapering’ or winding down its QE bond purchases. Fed Chair Powell’s recent utterances point to this starting in November or December. The key will be how much further progress is made in reaching full employment and last week’s weak payroll numbers have eased concerns of an earlier start to tapering. Interest rates, meanwhile, continue to look unlikely to rise until early 2023.
As regards bond yields, they should head higher. Even so, they should still remain relatively low and are unlikely to lead to more than gradual downward pressure on equity valuations. Price-earnings (P/E) ratios are anyway not looking as stretched as they were as the faster than expected recovery in corporate earnings has outpaced the gains in equity prices. The forward-looking global P/E ratio has fallen back to 18.5x from a high of 20-20.5x last year.
US equities have outperformed the rest of the world this year, with a return of 19.2% in sterling terms, while the UK has performed broadly in line with a return of 15.1%. These two countries currently account for around two-thirds of the equity exposure in our portfolios, with around 38% in the US and 31% in the UK.
Going forward, we favour the UK over the US with valuation the main reason. The US is looking increasingly expensive and the UK increasingly cheap. The P/E ratio of the US is now close to 45% higher than in the rest of the world, versus an average 22% premium over the last ten years. By contrast, the UK is close to 30% cheaper than elsewhere, significantly more than the average 10% discount.
This valuation divergence looks equally stark in absolute terms, with equities in the UK still looking fairly valued unlike in the US. Whereas the UK P/E ratio is currently 13.2x, in line with its 10-year average, the US P/E ratio of 21.5x is some 30% higher than its average level.
While valuation is rarely a good guide to short-term movements in markets, it has proven a much better guide in the medium to long-term, particularly at extremes. We believe valuations are sufficiently extreme now to warrant an underweight of the US and overweight of the UK. While our exposure still remains higher to the US than the UK, our US weight is significantly smaller and our UK weight rather larger than we would expect over the long term.
Chief Investment Officer