2017 Midyear Outlook | American Funds

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2017 Midyear Outlook

Key Takeaways

  • The global economic picture is brightening. Global equity markets should benefit from improving economic activity.
  • Market trends suggest better values may be found abroad, presenting opportunity in Europe and emerging markets.
  • Interest rates are gradually rising. Bonds can still play a key risk-dampening role in most portfolios.
  • Fundamentals trump politics. Global diversification can help offset localized political risk.

 

Global Economies and Markets: Momentum Builds

For the first time in years, the world’s major economies all appear to be on the road to recovery.

Nowhere is economic momentum more evident than in the U.S., where the economy is gaining strength and seeing more sectors participate. Since the end of the Great Recession, the U.S. recovery has largely been driven by a resilient consumer. But more recently, manufacturing has turned around. This should be supportive of equity markets barring any unexpected shocks or policy missteps.

That said, a look at the world’s market capitalization levels shows the U.S., at 53%, nearing the top of its historical range while overseas markets are near lows. Europe appears to have turned a corner and is poised to play catch-up.

With China stabilizing, emerging markets are roaring ahead and appear to have more room to run. Given the relatively wide chasm in valuation between U.S. and international stocks, it may be time to rebalance portfolios toward markets outside the U.S.
 

The U.S. and Emerging Economies, With Growth Accelerating, are Standouts in an Improving Landscape

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Sources: International Monetary Fund, World Economic Outlook Database, April 2017; MSCI; RIMES; Thomson Reuters. 2017 GDP figures are estimates. Market capitalization ranges represent each region’s percentage of the total market capitalization for the MSCI All Country World Index for the 20 years ended 5/31/17.

The U.S.: Economic Expansion Broadens

For more than seven years, the U.S. recovery has proceeded at a lackluster pace. But business- and industrial-focused areas have provided positive momentum to the overall growth picture. The Purchasing Managers’ Index (PMI) rose to 52.7 in mid-2017, indicating expansionary conditions. In addition, corporate profits, which came under pressure in 2015 and 2016, have rebounded, surging more than 13% in the first quarter of 2017.

Taken in combination with strengthening wage growth and retail sales, these conditions point to accelerating growth. On the policy front, easing regulations, combined with prospective tax reform, could provide a further boost to growth. That said, policy remains fluid and any missteps with regard to trade policy could have an adverse impact on the overall economy.
 

Built to Go the Distance: Manufacturing, Capital Spending and Earnings Are All Strengthening

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Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, FactSet, International Monetary Fund, Thomson Reuters. GDP is the actual 2016 and estimated 2017 GDP growth, as reported by the IMF. Earnings growth is year-over-year S&P 500 earnings growth in 1Q16 and 1Q17, as reported by FactSet. Retail sales is year-over-year change on 3/31/16 and 3/31/17. Capital expenditure growth is the year-over-year growth of U.S. manufacturing non-defense shipments, excluding aircrafts, on 3/31/16 and 3/31/17. Manufacturing PMI is the manufacturing component of the 4/30/16 and 4/30/17 PMI reports.

International Investments Present Opportunity for Selective Investors

Investment often goes where the growth is. Nowhere is this more evident than in Europe, where a number of agile global businesses have shifted their focus to the American consumer. Since 2008, shares of non-U.S. companies with significant exposure to the U.S. economy have done notably well. Challenges remain in Europe and Japan, but select companies may get a further lift as growth forecasts in both regions improve and consumer spending and manufacturing activity picks up.

Amid these signs of better economic growth and diminished political instability, there are a number of other reasons why international equities look more attractive. A gradually weakening U.S. dollar is helping to boost international investment returns for dollar-based investors. In addition, European equity valuations are appealing, particularly in relation to U.S. stocks, which have outpaced their European counterparts for more than eight years.
 

The Divergence in Returns Shows That Investing in Companies Is Not the Same as Investing in Economies

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Sources: Capital Group, FactSet, MSCI. Data represents cumulative relative returns of each category of non-U.S. companies to the MSCI ACWI since 12/31/07. “U.S.-oriented” includes all companies that generate over 40% of their revenues in the U.S. “Non-U.S.- oriented” includes all companies that generate less than 40% of their revenues in the U.S. Non-U.S. companies also exclude Canada. Returns are in USD as of 5/31/17.

After a Solid Rebound, There May Be Room to Run in Emerging Markets

Emerging market equities have surged 50% since a trough in early 2016, supported by a sustained stimulus program in China, demand for a range of commodities and a more stable U.S. dollar. Even after the recent rally, EM has only averaged a 4.5% return over the last five years, compared to 15.4% in the U.S. Overall valuations also remain attractive compared to developed markets. For instance, Brazil and China look like relative bargains, trading for less than 13 times projected earnings over the next year. Corporate profits are picking up too, and historically that’s been good for share prices. In aggregate, earnings for companies in emerging markets are estimated to increase 21% in 2017 — the best growth since 2010 if achieved. Strong earnings are expected from the technology sector, while companies domiciled in India, China and Brazil are projected to see stable growth through 2018 following several uneven years.
 

Emerging Markets Have Soared Since January 2016, but Valuations Remain Relatively Attractive

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Sources: FactSet; International Monetary Fund, World Economic Outlook Database, April 2017; MSCI; RIMES. Relative Valuation compares the forward 12-month price-earnings ratio of the MSCI World and MSCI Emerging Markets indexes as of 5/31/17. Estimated EPS Growth is as of 5/14/17. Total Return is from 1/21/16–5/31/17. GDP Growth is the estimated 2017 GDP Growth, as reported by the IMF.

Fixed Income: Don’t Bail on Bonds in a Rising Rate Environment

The Federal Reserve finally appears to be following through with its effort to move short-term rates higher. Policy expectations coming out of U.S. election results, paired with improving economies overseas, have helped brighten growth expectations, which have also helped to push yields higher.

Despite this backdrop, rates face an uphill battle. Policy changes may turn out more modest than the market’s best-case scenario and take longer to materialize. The Fed also remains very cautious in its tightening, as a sharp global shock could knock it off of its planned path. Add in continued robust demand from global and domestic investors for bonds, and yields may remain in a relatively low range. However, even if rates do rise more than these factors suggest, as long as they rise gradually, bond funds could absorb associated price declines. And an offset from higher yields can help to prevent losses in fixed income.
 

What Interest Rates Changes Mean for Investors

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Sources: Thomson Reuters. As of 3/31/17. Table calculations assume 5-year duration bonds, which would incur 5% capital losses for every 1% that rates rise.

Download our 2017 Midyear Outlook for an in-depth look at how economic momentum is building across the globe amid political uncertainty.


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