For the first time since 2010, developed and emerging markets seem to have found their synchronized groove. How should investors position?
High valuations across most asset classes, geopolitical uncertainty, and changes in monetary policy are fodder for investor angst. Yet, there are reasons to be optimistic, even as markets climb the last wall of worry.
Nearly half way through the year, the global economy has found surer footing, according to Morgan Stanley Research’s global economics team, which has raised its projections to 3.6% global GDP growth in 2017 and 3.7% growth in 2018, slightly higher than its outlook going into 2017.
Several factors support this rosier view, including a shift toward self-sustaining growth, improving private investment and steady central bank policies—to name a few—but synchronous growth is chief among them. “For the first time since 2010, developed markets and emerging markets are recovering in sync,” says Elga Bartsch, Co-Head of Global Economics. “That's a key change from the past seven years, when weakness in at least one major region offset strength elsewhere and created fragility that made the global economy more sensitive to shifts in growth at the margins.”
How should investors position? “We expect broad-based growth and contained inflation to drive more animal spirits,” says Andrew Sheets, Chief Cross-Asset Strategist. Morgan Stanley's global strategy team’s playbook for the second half of 2017: Overweight U.S. and Japanese equities, and in most regions, financials and information technology; look for a strengthening euro, relative to the dollar; take another look at emerging market debt; and be wary of credit, a common late-cycle loser.
This outlook isn't without caveats. For one thing, it depends in part on the current steady state of low market volatility. “If volatility rises sharply, investors and companies will likely go back into their shells,” says Sheets. Morgan Stanley's forecast also assumes that growth picks up, while headline inflation stays tame.
Beyond 2017, returns may not come as easily. If the current outlook runs its course, valuations will be ever richer for both stocks and bonds, and central bank tightening may be more meaningful. “The challenges of 2018 are a reason why we are constructive now,” says Sheets, adding: “Make hay while the sun shines.”
Options markets have assigned low odds to a +10% increase in U.S. stocks, but this view may be too narrow. “We think this is putting too much weight on valuations, and not enough on the combination of growing earnings, easy money and animal spirits,” says U.S. Chief Investment Officer Mike Wilson.
Morgan Stanley’s U.S. market strategists forecast 12% earnings-per-share growth for the S&P 500 in 2017. Meanwhile, they expect stable U.S. yields, with the 10-year Treasury at 2.4% in the second quarter of 2018. This outlook assumes that the Federal Reserve will raise key interest rates six more time between now and December, 2018, coupled with balance-sheet reductions.
Across regional markets, particularly in the U.S., information technology and financials may offer the most upside potential. “IT has stronger trend earnings growth and return on equity than the market,” Sheets says. “Financials stand to benefit from synchronous global economic growth and reduced regulatory; it's also the cheapest sector on plain-vanilla forward price-to-earnings.”
Japanese equities also should continue to see upside, thanks to a weaker yen, long-awaited domestic growth and increasing exports, a beneficiary of the improving global economy. Morgan Stanley has upgraded Japan’s real GDP growth to 1.6% for 2017 and 1.1% for 2018, up from previous forecasts of 1.3% and 0.9%, respectively.
Although Japan's market has rallied this year, Morgan Stanley’s strategists note that investors haven’t fully priced in earnings growth, wage inflation and support from external demand. “We're long Japan equities–currency hedged–and think it still offers attractive valuation,” says Sheets.
Meanwhile, Europe's economy has reached a comfortable cruising speed. Bartsch now forecasts 2017 GDP growth of 1.9% for the eurozone, a 10-basis-point increase from Morgan Stanley’s previous estimate.
However, equities in the region aren't the bargain they were in late 2016; a stronger euro also is likely.
“Our decision to upgrade Europe at the end of last year was driven by our belief that we would see a solid upturn in the eurozone economy, earnings and investment flows into a region that was unloved and underowned,” says Sheets. “Over the last few months, each of these catalysts have occurred.” One caveat: Value may be in the early innings of a recovery, after prolonged underperformance.
Looking to the UK, economists expect slower growth as rising inflation dampens real consumer spending growth, and Brexit-related uncertainty limits private investment.
While every country poses its own risks and opportunities, as a group, emerging markets offer still-reasonable valuations and improving macro fundamentals. Overall, Morgan Stanley expects GDP growth to improve from 4.2% in 2016 to 4.7% in 2017—and with the potential for 5% GDP growth in 2018.
China, which is still central to this story, will likely continue to see a gradual slowdown of economic growth, but it is improving, nonetheless. Look for real GDP growth to increase to 6.6% in 2017 and 6.4% in 2018. More importantly, the economic powerhouse is no longer under a cloud of disinflation, and growth of its debt/GDP ratio has moderated.
Following a 7.9% jump in GDP in 2016, India's economy will likely accelerate going into the second half of this year and begin firing on cylinders in 2018, fueled by growth in consumption, public capital expenditures and external demand. Morgan Stanley sees a base-case increase of 6.6% in 2017 and 8.0% in 2018.
In Brazil, meanwhile, the story is still about political uncertainty, coupled with improving fundamentals. “A healthier balance of payments and lower inflation mean that the central bank can continue to cut rates, creating some support for growth in 2018,” says Arthur Carvalho, Head of Latin America Economics. Strong real income should stabilize household consumption and lead companies to rebuild their inventories. Carvalho believes that Brazil’s battered economy could grow this year—albeit at a very modest 0.5%—than ramp to 2.5% in 2018.
While these countries are major contributors to global GDP, the best investment opportunities may be in local market debt in Mexico, Poland and Indonesia, and in sovereign credit in Ukraine and Argentina. “We are bullish on emerging market local rates, currencies and sovereign credit," says Gordian Kemen, Global Head of Emerging Market Fixed Income Strategy. Kemen points to supportive global macro conditions and attractive valuations, coupled with inflows.
For more Morgan Stanley Research on the 2017 global midyear economic, policy and market strategy outlooks, ask your Morgan Stanley representative or Financial Advisor for the full reports,“2017 Global Macro Mid-Year Outlook: Transitioning to Self-Sustaining Growth” and “2017 Global Strategy Mid-Year Outlook: Climbing the Last Wall of Worry” (Jun 4, 2017). Plus, more Ideas.