Global equity markets continue to shrug off risksIn several ways, 2017 has defied expectations. In the United States, economic growth, which was expected to accelerate, has been underwhelming. Inflation and interest rates were expected to increase, but inflation has been stagnant and the 10-year Treasury yield is on track to end the year lower than where it began. Cyclical and value stocks have underperformed significantly. There is disappointment over a stalled legislative agenda in Washington, discomfort with rising equity valuations, and narrow market leadership from a handful of large-cap growth stocks. Yet U.S. equities have moved steadily higher, setting multiple records, with the S&P 500 Index breaking 2,500 for the first time in September.
Even more unexpected, however, is the performance of markets outside the United States, which have also been largely unfazed by uncertainties. They have performed well despite the distraction of escalating geopolitical tensions, a contentious European electoral cycle, continued uncertainty over the implications of Brexit, and the risk of a more protectionist U.S. trade policy. The biggest rally occurred in emerging markets stocks. The MSCI Emerging Markets Index in September reached its highest level in six years.
Putting valuations in perspective: Is Europe compellingly cheap?As we enter the final quarter of 2017, the chief issue for global equity markets is valuation levels. A common belief is that multiples are too high, and that U.S. equities in particular are expensive relative to Europe. In our analysis of valuations in the U.S. and European markets, we find that more than half of the discrepancy in average P/E multiples can be attributed to differences in industry weightings. European equities appear cheaper, but the MSCI Europe Index generally has higher weightings in lower-multiple sectors such as energy and financials, while the S&P 500 Index has larger weightings in the higher-multiple technology sector. Additionally Amazon, a high P/E (200+ times), mega-cap constituent in the consumer discretionary sector, has no equivalent in Europe. It alone accounts for another 10% of the difference in the valuation spread between the United States and Europe. This observation does not mean that Europe offers nothing. Fundamental research can uncover many attractive opportunities among European equities today. But seeking broad exposure to Europe based solely on valuation levels may be misguided.
Positive synchronization across global economies may help extend the rallyIt is natural to look toward 2018 and wonder how equities can advance further without certain catalysts, such as greater acceleration in economic growth. However, the markets have enjoyed some positive trends that could continue to support stock performance. The first is corporate earnings growth. In the United States, S&P 500 companies just saw a second consecutive quarter of double-digit growth for the first time since 2011. Wall Street's forecasts are for 10% growth in 2018, and there has been constructive guidance from businesses overall.
The most encouraging factor for equities today may be the impressive level of synchronized global economic improvement. Global equity markets often stumble as a result of serious economic woes in a specific region, such as the eurozone debt problems of 2010 and 2012 or the China slowdown fears in 2016. Today, however, we have decent economic conditions in the United States, improvement in Europe, and impressive growth in China. Global economic variables are more in sync now than at almost any other time since the Great Recession.
Sectors to watch: Value and cyclicalsThroughout 2017, the bulk of U.S. equity performance has been in growth stocks at the expense of value stocks. While it is not unusual for the styles to diverge, there has been a dramatic bifurcation this year. The highest P/E stocks continue to outperform the lowest P/E stocks — consistently and by a considerable margin. As we assess the macroeconomic and earnings environment, we find the most relative value in cyclical sectors.
In areas such as energy and industrials, many fundamentally strong companies with exposure to key growth trends are trading at below-market multiples. Another sector that stands out is financials. These companies have struggled recently, but with improving global macroeconomic trends and the potential for rising interest rates, we believe they are poised for improvement.