Vale 2017/18: part 1

Chief Economist's View

As financial year (FY) 2017/18 passes into history, the world stands at the dawn of a new era. A new era for financial markets as central bank policy emerges from quantitative easing. A new era for the global economy, facing a return to tariffs and protectionism and Keynesian fiscal stimulus. A new era for politics, with the rise of populism and the fall of internationalism.

This week’s Brief is the first of a two-part series that reviews the FY just completed and takes a crystal ball to 2018/19. We start the series with a look at financial markets.

Overall, it was a good year for investors as global equity markets (as measured by the MSCI All World Net Total Return) delivered a net total return (price rise plus dividend) of around 10%, while bond markets (as measured by Bloomberg Barclays Global Total Return Index) returned around 1%. The strength of equity markets means that a typical balanced fund (with a 50/50 split between equities and bonds) will probably deliver a return of around 6% and a typical growth fund (with a weight to equities of about 70%) will deliver a return of around 8%.

Over the year, global equity markets drafted the US market as the Trump/Republican tax package and a strong company earnings outlook drove a 12% increase in the S&P 500. Leading into the 2017/18 FY, the greatest risk facing equity markets was rising interest rates as the US Federal Reserve embarked on a sustained path of tighter monetary policy.

However, as it transpired the US and global equity markets absorbed higher interest rates in their stride. Now, it is the spectre of a global trade war that hangs over financial markets. Our analyses show that an escalation of the trade war that leads to tariffs on all bilateral trade between China and the US, a breakdown of NAFTA and a spread to Europe is enough to drive the US economy into recession and US equities into a bear market. But this result is obvious and therefore of little insight.

A more interesting risk is how vulnerable equity markets have become to a dip in sentiment after a bull run lasting almost a decade. We consider three factors that could cause such a dip: a reversion in risk premia, a disappointment in earnings outcomes and higher interest rates. We confine our analysis to the world’s dominant equity market; the US. We find that a reversion of risk premia to longer run levels will result in a modest drop in the S&P 500 modestly of around 5%.

The second risk to the equity market is disappointing company earnings. According to IBES analysts, earnings of S&P 500 companies is expected to grow by more than 10% over 2018/19.

Given the strong backdrop to the US economy afforded by the Trump/Republican fiscal stimulus and the generally robust fundamentals underpinning the consumer and businesses, the possibility of double digit company earnings growth is high; even if it is from a high base. Notwithstanding a robust economic outlook for the US and global economies, we would consider analysts’ projections of company earnings growth optimistic; but only slightly so.

Our outlook for S&P 500 company earnings growth is closer to 5% than 10%. The third risk posed to equities is that of higher interest rates. As we have written in previous Briefs, our view is that the US equity market is discounting company earnings with a higher real interest rate than is currently priced in Treasury bond markets; with the differential around 70 basis points higher than current market pricing. A higher rate used to discount equities than priced in bond markets is consistent with the compression in the differential in the price/earnings ratio of the S&P 500 to the US 10-year real government bond yield over recent years.

As bond yields rise, the differential with the S&P 500’s P/E ratio will unwind, meaning that the US real 10-year bond yield can continue to rise by around another 70 bps before the rise in yields begins to undermine US equity prices. Bringing the three factors together, our view is that the US equity market is only modestly overvalued; within a range of 10% to 15%.

We expect this mis-valuation to unwind gradually over 2018/19. Consequently, we expect equity prices to move sideways over the coming year. With equity markets treading water and interest rates continuing to climb higher, 2018/19 will prove to be a much tougher time for investors than 2017/18.

Table 1: Financial market movements, 21 - 28 June 2018

Equity index



10-yr government bond



Foreign exchange



S&P 500





-6.0 bps

US Dollar Index (DXY)



Nikkei 225





-0.4 bps




FTSE 100





-1.4 bps









-1.6 bps




S&P/ASX 200





-5.5 bps




Source: Bloomberg

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