Global markets have entered a range-bound realm where recession does not appear to be on the horizon, yet growth prospects are tepid, at best. Welcome to the new mediocre.
In the U.S., equities remain expensive with the S&P 500 recently reaching record highs in the midst of a pervasive corporate earnings slump that is rare outside of an economic recession. In the first quarter of this year, S&P 500 profits declined 8 percent relative to last year, with six of the 10 major sectors reporting negative growth. Despite the stronger than expected start to the current earnings season, we expect profits to remain negative this quarter, staying in the range of negative 4 or 5 percent.
The big question is what the earnings picture will look like over the next couple of quarters. With the U.S. economy on track to continue grinding forward, supported by a strong U.S. consumer and improving labor market, we expect S&P 500 earnings growth to move out of negative territory, returning to zero over the next 12 months as passing headwinds from low energy prices and a strong U.S. dollar fade. From there, rising labor costs and slowing profits from foreign operations will likely keep U.S. earnings growth stuck in the low single digits over the next three years.
The picture outside the U.S. is similarly lackluster. Global gross domestic product (GDP) growth—which appeared promising at the beginning of 2016—has been sluggish, while July saw U.S. and other global bond yields hit record lows. In addition, uncertainty around geopolitical events means that more volatility is likely.
Where do investors turn in the new mediocre?
Looking at equities, the combination of expensive valuations and lackluster earnings make U.S. equities largely unattractive. We do see “quality” stocks that offer consistent earnings power as a good value, but investors have to be disciplined and selective.
We see greater potential opportunities in equities outside the U.S., with more compelling valuations in the Japanese and European equity markets. Emerging market equities are also inexpensive, however their attractive valuations are offset by a slightly weaker business environment.
In fixed income, investors should think twice about trying to fight the U.S. Federal Reserve, the Bank of Japan or the European Central Bank. Wages are gradually picking up in the U.S. and putting pressure on the Fed to raise rates, while both the ECB and BoJ are contemplating further unconventional easing to bolster inflation expectations. The net result is that the upward pressure on bond yields from inflation pressures in the U.S. likely will be muted by deflation pressures in the rest of the world. We believe bond yields are likely to rise, but only modestly.
Currencies will likely stay in the ranges they have traded in since the beginning of 2016, with the USD potentially pushing toward the top of that range. Emerging market currencies appear to have attractive valuations, but China’s exchange rate policy in our view presents a looming risk.
Volatility often provides some investors with the source of opportunity they seek, but even that has been lackluster. In our view, the initial market swings from last month’s Brexit-sparked volatility did not prove significant enough to warrant taking on more risk by buying into a market dip.
In this environment of mixed signals and uncertainty, investors may find themselves with only mediocre options. That means perhaps the best chance of meeting their objectives may be a globally diversified, multi-asset portfolio that has a range of return drivers, even if many of those drivers are not perfect.
As Confucius said, “Better a diamond with a flaw than a pebble without.”
Paul Eitelman, multi-asset investment strategist, joined Russell Investments in March 2015. Prior to joining Russell, Eitelman served as Vice President and Senior Economist at J.P. Morgan Private Bank. He previously worked at the Federal Reserve Board, where he was the lead economic analyst for several emerging market economies in Latin America and Southeast Asia. @Russell_Invest