Investors are caught in a tug of war between economics and politics. The political landscape remains pretty uncertain, even after the worse-than-expected result for the far right in the recent Dutch elections. Balancing this concern, the economic environment is fairly supportive with a powerful reflationary backdrop.
So far retail investors have been edging on the optimistic side, but with a clear lack of selectivity across all asset classes and geographies as evidenced by the inflows in passive funds, this could prove dangerous.
This year is proving to be a turning point for economists and investors as we reach a position of peak globalisation and liquidity. The movement towards ever greater globalisation that has shaped macroeconomics over many decades is now grinding to a halt following the Brexit vote and Donald Trump’s US electoral victory. The prospect of greater trade friction is a real possibility, considering the mercantilist agenda of the new US administration.
Add to this the rising inflation that will temper the ability of central banks to deploy and sustain the quantitative easing that previously lifted all boats. That period is over. If the speed of the monetary policy normalisation is open to debate, the direction is nevertheless clear.
With equity valuations already high, the scope for further multiple expansion is therefore constrained, and from now on stock performance will have to rely mainly on earnings growth.
The good news is that thanks to the improved economic backdrop, earnings estimates have not been aggressively revised downwards by analysts, as has been the case every year since 2011. The bad news is that stock performance will be increasingly sensitive to the varying fortunes of specific companies’ earnings upgrades and downgrades as we saw during the last earnings season. The need for investors to deploy selectivity is becoming more important.
There are compelling investment opportunities in stocks that are geared to the acceleration of the economic cycle, but that are also relatively immune to the political environment. Cement producers such as Cemex or LafargeHolcim are local businesses that are direct beneficiaries of the pick-up in inflation – translating into a nice operating leverage impact on earnings, as well as of the commitment to increase the decades-low level of infrastructure spending in the US.
In the search for US cyclical stocks, investors should beware of sectors that remain unattractive even in a reflationary environment, such as the car industry. It is estimated that US car manufacturers save between $3bn (£2.4bn) and $4bn per year thanks to outsourcing some of their manufacturing to Canada and Mexico, something that makes them quite vulnerable to future trade restrictions. Furthermore, as financing conditions become tighter their continuous use of aggressive vendor financing is unhealthy.
Beyond the US, Japanese banks present an attractive combination of cheap valuations – with a price-to-book ratio of just 0.7 times, in line with European banks but well below American banks – and appealing earnings growth. The potential of Japanese banks relies on strong balance sheets giving them plenty of leeway to lend more, and also on the visibility of the new yield curve control policy of the Bank of Japan.
