As we enter the second half of the year, markets now appear to reflect a somewhat cautious optimism.
Experimental central bank monetary policy across the globe has fuelled global stock price appreciation, but a dangerous dependency on stimulus to generate ever-higher market returns is a possible side effect.
This could present challenges for future equity market performance as major central banks gradually move to normalise extraordinarily supportive policy measures.
In the current environment, we think long-term investors should not buy equities indiscriminately.
However, we do see pockets of opportunity in certain markets and sectors across the globe.
We believe this is an environment where value discipline and active risk management will be rewarded over the long-term.
China’s year of calm
The Chinese government’s recent measures to rein in credit creation and fiscal stimulus while avoiding a major economic slowdown appear to be proceeding steadily.
We expect these themes to remain dominant ahead of this year's 19th National Congress assembly.
Nevertheless, we cannot ignore the country’s sizable credit excesses, the result of an investment boom that led to overcapacity in real estate and industrial sectors.
If China’s economy slows too much, we believe China is likely to shelve its newer reforms and return to past measures to boost growth.
We’ve avoided the vulnerable and opaque banking sector, state-owned enterprises and the oversupplied industrial complex.
We see value in companies with underappreciated growth potential – in the health care, insurance, IT and certain franchises in the telecom sector.
Uncertainty in the US
Despite the ongoing resiliency of the US economy and equity markets, we have a few concerns.
Investor confidence in President Trump’s ability to enact pro-business policies appears to have diminished since last year’s election.
It’s unclear if his plans to lower taxes or boost infrastructure spending will actually materialise in legislation.
Also, after eight years of unconventional Federal Reserve stimulus, US stocks are on the second-longest winning streak since World War II.
We believe Fed members would face challenges as they transition to a more sustainable monetary policy framework.
US stocks aren’t cheap and do not adequately reflect the political and market risks.
However, we do see value in select technology, financial and health care stocks, and in the beaten-down energy sector.
Europe’s move to growth
During the past six months, positive economic growth, supportive monetary policy and market-friendly election results have benefited European markets.
Recently elected French President Emmanuel Macron’s consolidation of power in the legislature offers opportunities for pro-business reforms.
Overall, the euro-area economy has been experiencing a broad recovery and transitioning to a multi-year growth cycle.
In fact, European GDP growth has outpaced US growth over the past year and corporate profits have been accelerating.
We also see signs that interest rates are moving upward in some countries, with the potential for further increases ahead.
Financial stocks stand to benefit from higher rates, as well as from the increasing demand for credit in the eurozone.
This combined with declining loan losses, more favourable regulations and tighter costs controls are boosting bank earnings growth expectations.
We continue to find attractive opportunities in financials, as well as in the industrials, materials and energy sectors.
United Kingdom’s political disarray
The UK has had a tougher time than broader Europe.
Prime Minister Theresa May’s grave electoral miscalculation was the latest episode in the unfolding spectacle that is Brexit.
Despite the justifiable macro concerns in the UK, we see value in certain stocks, predominately multinational corporations with sizable overseas revenues.
These types of companies, while domiciled in the UK, have less exposure to domestic economic pressures.
Opportunities in emerging markets
Emerging market valuations appear attractive when compared with developed markets based on a number of metrics. However, we remain selective stock pickers.
Weakness in the Asian tech cycle, global trade or a more notable slowdown in China’s economy could negatively impact equity market returns.
A slump in commodity prices and waning US dollar liquidity as the Fed downsizes its balance sheet are two additional risks that could negatively impact emerging market equities.
We’ve found most of our emerging market bargains in Asia, where we see corporate governance slowly improving.
Among Asian emerging markets we would point to South Korea as perhaps the best example of the corporate governance improvements and reforms in the Asian region.
The country’s banking sector stands to benefit from this political stability, in addition to economic growth and rising interest rates.
Putting it all together
In our view, corporate earnings and cash flow generation will matter most for equity returns going forward.
We remain highly focused on corporate business trends and company fundamentals. We think central-bank policy will continue to demand market attention in the second half of the year.
With that in mind, we also think investors should consider preparing for rising volatility following an unusually quiet period for global financial markets.
We are most interested in stocks that appear currently undervalued relative to long-term business fundamentals, as well as stocks that offer some degree of counter-cyclical or contrarian defensive characteristics should the US-led, central bank-fueled bull market eventually run out of steam.
Peter Wilmshurst is a portfolio manager on the Templeton Global Growth Fund.
