As the equity bull market enters its seventh year, the global economy nears several inflection points and new equity market leaders will likely emerge. The US economy has strengthened to the point where the Federal Reserve (Fed) is preparing to raise interest rates for the first time since June 2006. The euro has depreciated to match the European Central Bank’s (ECB) near-zero interest rate and banks are lending again after years of deleveraging. In Japan, inflation is taking hold, wages are rising and consumption may be about to pick up. In our view, the macroeconomic themes behind many of these changes—diverging monetary policies and currencies, low oil prices and structural reforms—affect every company’s earnings and stock price in a unique way.
A Strong Dollar, Cheap Oil Kind of World
The effect of diverging monetary policy on currencies is becoming more pronounced and we are increasingly focused on the impacts of a strong US dollar. With the Fed on the cusp of raising rates and the Bank of Japan (BoJ) and ECB still in easing mode, the US dollar has continued to strengthen against the yen and especially the euro, where the exchange rate is approaching parity. The weak currencies are a boon to Europe and Japan, both of which have many export-oriented companies which are beginning to report the positive effect on their earnings. In the US, the strong dollar is likely to be good for consumption, which is critical for the US economy because it accounts for roughly 70% of GDP. However, corporate earnings are increasingly likely to reflect the negative effects of a strong currency. While the immediate effect of currency translation may be a near-term hit to earnings, we are more concerned about competitive disadvantage, which can have longer-term consequences.
Just as the dollar looks likely to stay strong, we believe oil prices are unlikely to rise soon because even the substantial capital spending (capex) cuts already announced will have a limited effect on supply in the next few quarters. Like the strong dollar, low oil prices can have a mixed effect on economies. Generally, consumers and manufacturers will benefit from cheaper fuel and energy costs, but the US also has a large energy industry and many companies with energy-related businesses have been reducing earnings estimates. Big oil importers like Europe and Japan are benefitting from lower energy prices however the deflationary impact is a potential risk for these regions.
Structural Reforms: The Road Sometimes Taken
Structural reforms—or the lack thereof—continue to impact equity markets and influence our views. Scepticism about the abilities of Europe and Japan to execute on necessary reforms has held back both their economies and equity markets. Europe still has big issues to tackle, but has made important progress with its banking system. Japan is making a renewed effort at reform with Abenomics. Industries also face periods of structural change. The banking system reforms in the US and Europe strengthened banks’ balance sheets and instilled confidence again, which contribute to our more positive view on financial stocks. Now, the energy industry is seeking ways to reduce a structural oversupply of oil. Capex and production cuts are a start and many companies may further restructure themselves to be profitable in a world with lower oil prices. These changes will take time, hence our continued cautious approach to investing in energy stocks.
Differentiating Equities From Economies; Selecting Stocks, Not Stock Markets
Naturally, we believe new equity market leaders are likely to emerge from the changing macroeconomic landscape. But the best performing stocks and stock markets may not necessarily be in the countries or industries with the highest growth, and yesterday’s laggards are not always ready to be tomorrow’s leaders. Furthermore, earnings multiples have crept up, leaving few bargains. We think global equity returns for the year will be slightly below their 8-10% long-term average , which we once again believe will compare favourably with other asset classes. We believe earnings growth will become an increasingly important driver of stock performance because multiples have already expanded. In addition, the sometimes offsetting or contradicting effects of macroeconomic conditions will make top-down calls more difficult, but we believe the true impact will be revealed in corporate earnings.
At GSAM, we believe more expensive equities, lower return expectations and offsetting macro influences create a stock-picker’s market and one in which portfolios that outperform may look very different from the broader market. Even when sector and country weightings are similar, a closer look may reveal differentiation through concentration, market-cap, quality or many other characteristics. Last year was once again challenging for most active managers, especially in the US, but we think that is about to change.