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Market View

Market confidence fuelled by good company earnings growth

 

As publicly traded companies announce strong earnings growth for the last three months, markets have had a relatively muted reaction, meaning good results were expected. As the global economy heads into 2018 on a reasonably sure footing, it’s tough to keep perspective when things are looking so positive.

This time last year we were concerned that earnings growth was largely driven by cost containment rather than businesses growing their revenue. But third quarter earnings reports in the US show that the revenue growth momentum we saw earlier in the year continues to hold up. So far sales growth is at 6.2%, contributing to an increase in earnings growth of 8.0% (as at 01.11.17), going some way to justify stock market highs.

US earnings

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Sectors performing particularly strongly include technology, as well as oil and gas. It’s no surprise to see technology deliver the fastest growth, but it’s impressive nonetheless given that 7 of the 10 largest businesses in the world are tech companies. The success of the oil and gas sector is largely attributable to a terrible 2016, so the growth is really just a return to profitability.

Meanwhile, the financial sector is not faring so well. Financial services firms make money when there is volatility, and so they have not done particularly well in their trading divisions. Businesses listed in the UK do not have to report quarterly earnings so there are fewer companies reporting here. So far though, the outlook is positive for those that have. Sales growth is up 6%, and earnings growth is up 4%, although we should be careful not to take this at face value as a few outliers are disproportionately affecting this reading. Good performance is largely attributable to the fact that most UK-based businesses earn a significant proportion of their revenue outside of the UK. With the weakness of the pound after Brexit, and the euro showing increasing strength, it’s no surprise that sterling profits are higher.

“Market confidence remains high, as do equity valuations. While this is positive news for investors, we must remain disciplined and not let short-term optimism take us away from a robust valuation orientated framework. After all, it’s when valuations are reflecting the most optimistic outcome that the risk of a surprise is highest.” - Philip Smeaton, Chief Investment Officer

Positioning for growth, whilst protecting from downside risk

As markets continue to ride the crest of a wave, and global growth remains strong, it feels slightly negative to be talking about downside risk. But we wouldn’t be doing our job if we didn’t feel concerned about inflated asset prices, and what a market correction could mean for our clients. In previous months, we’ve reported an underweight position in equities – especially in the US where prices are particularly high. Of course, being underweight in an asset class doesn’t meanwe’re not invested and able to reap the rewards that are out there. But, as markets rise, it’s important to be mindful of the increasing level of risk for investors, as a negative economic surprise would lead to a larger fall in asset prices.

To express a moderately cautious outlook whilst still being ‘in play’, we’re looking at moving cash into a defensive structured product called an Autocall. This is a complex product that trades some of the upside for protection against the first part of a market’s fall. For example, it promises to return roughly 7% per annum whether or not markets continue to rally. In fact, if equity markets fall by up to 40% by the time the product matures in six years’ time, the product still delivers 7% per annum. It’s not risk free, however. If equity markets fall more than 40% at maturity, then this product will underperform. However, history suggests that this outcome is unlikely, and we have selected equities where we think the risk is even further reduced. We certainly feel it complements other holdings, particularly in an environment where there are few opportunities.

Bank of England increases interest rates

The UK has not seen an increase in its base rate for over 10 years, so this month’s announcement marks a significant moment, even if markets saw it coming. The graph below reminds us how quickly, and by how far, the rate of interest fell in the wake of the 2008 financial crisis, and for how long it has remained close to zero.

UK Base Interest rate

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Source: Bloomberg

The Monetary Policy Committee (MPC) has a clear mandate to keep inflation at 2%. This maintains price stability, and gives people confidence that the currency will maintain most of its purchasing power. With the Consumer Prices Index (CPI) rising to 3% in September, its highest level since April 2012, the MPC has taken preventative action to head off the possibility of further inflation increases, and the need for aggressive rate hikes in the future. We don’t think this is the start of a series of rate increases. Indeed, we believe inflation will return to target levels of its own volition, as the effects of a weak Sterling dissipate.

“The UK economic environment remains challenging, with consumer and government spending expected to be flatl whilst the Brexit negotiations delay business investment. We expect the inflation outlook to stabilise, and consequently for this to be the first, and last, interest rate hike we will see for a while. Hopefully a continued low interest rate environment can offset some of the reasons to be cautious.” - Matthew Brittain, Investment Analyst


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This article is for information purposes and should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed above are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by Sanlam Private Wealth. Any expressions of opinion are subject to change without notice. Reproduction of this commentary is not allowed in whole or in part without prior written agreement from ‘Sanlam Private Wealth. Past performance is not a reliable indicator of future results. Investing involves risk. The value of investments, and the income from them, may fall as well as rise.

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.