Although the effects of these moves will bear watching, we would point out that central bank-driven liquidity remains significant and should continue to buttress global growth. The balance sheets at the European Central Bank (ECB) and Bank of Japan are bigger than the Fed’s as a percentage of gross domestic product (GDP) and should continue to support global equities. So long as rate hikes and policy changes are gradual and well communicated, we believe markets can take the moves in stride. Even emerging markets need not necessarily fear tighter Fed policy and a potentially stronger U.S. dollar so long as the dollar moves steadily. We believe the positive economic forces currently present in the global economy will remain strong enough to overcome the potentially negative impact tighter policy will have, but we could see some short-term volatility as markets adjust.
Better Opportunities Outside The United States
Corporate earnings and relative valuations also to some degree have mirrored where the major economies are in their recoveries as of November 2017. And we believe positive economic and earnings visibility have been behind equity market returns during 2017, a trend that can continue in 2018 so long as earnings growth maintains momentum. U.S. earnings have recovered strongly and are now past their prior peaks, but with corporate earnings beginning to show increasing strength outside the United States, we believe an opportunity exists for those stock markets to lead global equities over the coming year. Additionally, market correlations have declined substantially, creating greater opportunity to differentiate between markets and focus on individual stock selection.
In Europe, we expect earnings to recover alongside a pickup in inflation over time. Modestly higher interest rates can benefit earnings in the financials sector, while rising commodity prices would tend to benefit energy and materials companies. We do remain somewhat cautious on the broader developed markets in general, however, as equities may be “priced to perfection”—any disappointment in earnings or rapid increase in interest rates could prove disruptive. In Europe and Japan, equity valuations as of October 2017 were still below their post-crisis peak in 2015, though close to their long-term historical averages.
In Asia, we expect strong economic growth in China and India to feed through to better corporate profits across the region. Already, we are seeing many emerging markets trade more on corporate and sector fundamentals than on broader macroeconomic trends, something we anticipate should continue in 2018. Furthermore, China’s emphasis on consumption over government investment and India’s ongoing structural reform efforts may create conditions for continued economic and corporate earnings growth over both the short and longer terms.