Download Outlook on Global Equity Income

Outlook on Global Equity Income
Summary
• The selloff in bonds during
the quarter drove a rotation
away from cyclical value
stocks back to defensives
and companies perceived
to offer secular growth,
reversing the trend that took
place in 2016.
• The direction of travel in
global monetary policy is
clear, as the debate now
revolves around the timing
and pace of rate hikes and
balance sheet normalization.
• While valuation focused
strategies have struggled
during this period of
artificially low rates, we feel
they are well positioned for
a new environment of more
traditional monetary policy.
JUL
2017
Global equity markets continued to rally during the second quarter even
as inflation expectations and interest rates fell and US economic data
disappointed. The decline in rates drove a rotation away from cyclical value
stocks back to defensives and companies perceived to offer secular growth,
reversing the trend that took place in 2016. Global equities generated midsingle digit returns in local currency terms during the second quarter although
the steady index level returns masked significant divergence among individual
sectors. Technology significantly outperformed, particularly social media
companies and other technology stocks perceived to offer secular growth,
as did healthcare, which rebounded as concerns over tighter US regulation
of drug prices abated. In contrast, commodity sectors, such as materials and
particularly energy, significantly underperformed. More defensive sectors
were mixed as consumer staples and utilities performed in line with the broad
market while telecoms significantly lagged, which was surprising since the
group typically does well amid declining rates. European stocks benefited
from political risk abating following the French election while stocks in Asia
performed well, driven by China. The US market lagged modestly, despite
strength in technology growth stocks, while returns in Latin America were
weighed down by increased political uncertainty in Brazil.
While the decline in oil prices and weakness in US economic data this year
have understandably led investors to question the potential for normalization
in inflationary pressures, we do not believe the global economic outlook
has changed dramatically since the beginning of the year. While there has
been some pullback in indicators of expected global growth and inflation
this year, the environment remains one characterized by a slowly improving
global economy with central banks around the world moving toward
reducing monetary stimulus. Much of the decline in inflation expectations
has been due to oil prices falling and no longer being meaningfully higher on a year-on-year basis. The oil price weakness
has been a function of elevated supply as US shale production has been resilient while demand, a better indicator of the
economic outlook, continues to be above expectations. In addition, broader measures of commodity prices remain near
levels seen at the beginning of the year and global trade continues to recover. Credit spreads globally remain very low,
lacking signs of market stress seen early in 2016 when oil prices fell sharply. Corporate earnings have been strong and
estimates of future earnings are being uncharacteristically revised higher, particularly among more cyclical companies. In
addition, surveys of business and consumer confidence remain robust and labor markets around the world are improving.
The relative performance of value strategies has been highly sensitive to bond yields and inflation expectations in recent years
so it is not surprising that value has struggled so far in 2017. However, the underperformance of value has overshot what
would have been expected from the move in interest rates as rates remain well above their levels from a year ago while value
has given back all of its outperformance in the second half of 2016.
US growth has clearly slowed during the past 18 months but the remainder of the developed world has accelerated leading
to much more consistent growth rates around the world. This has weighed on the US dollar, which had been supported by
inflows seeking more attractive investment opportunities in a faster growing economy. However we feel this synchronized
pattern of global growth is more sustainable and less likely to be derailed by an economic shock emanating from a particular
country. This contrasts with the environment in recent years when nearly all global growth was driven by the US and China.
Europe appears to finally be truly recovering after languishing since the global financial crisis as first quarter growth exceeded
expectations and leading indicators of growth are at high levels. Private sector credit growth has turned positive after
declining during the sovereign debt crisis, leading to a rebound in capital spending. In emerging markets, major countries
such as Brazil and Russia are expected to rebound from recessions while China continues to grow at a very robust rate.
RD22125
Outlook on Global Equity Income
The US remains a broadly expensive market with income stocks within the US trading at an uncharacteristic valuation premium. In
addition, US growth rates are no longer above that of other developed regions while political uncertainty in the US has also clearly
increased. In contrast, the political environment in Europe has improved. The uncertainty created by the UK Brexit vote and the
election of Donald Trump seems to have slowed the move toward populism in Europe, with centrists winning elections in France and
the Netherlands and populists losing support in Italy. In addition, valuations are much more attractive in Europe relative to the US, and
we believe European companies have a much higher likelihood of a cyclical improvement in earnings given that they remain depressed
versus history—unlike US earnings, which have already rebounded to new highs. Emerging markets continue to offer the most attractive
valuations globally. Emerging markets have now outperformed for over a year as fears of a Chinese hard landing have abated and
commodity prices have stabilized. An environment of US dollar weakness and stable commodity prices is also supportive of emerging
markets equities, and we believe the inclusion of China’s domestic “A” shares in MSCI indices is likely to improve sentiment further. In
addition, investors have begun to appreciate that in a world starved of robust GDP growth, companies operating in environments with
structurally faster growth are attractive.
The strategy’s sector allocation detracted from performance in 2017 as energy, a sizable weight in the strategy, lagged materially. In addition,
within defensive sectors the strategy had a heavy exposure to telecoms since valuations remain in line with historical norms and as their
domestic orientation provide insulation from potential increased protectionism. Exposure to consumer staples and utilities was much lower
as valuations in these groups are well above historic norms. This positioning was detrimental as staples and utilities significantly outperformed
telecoms. Sector deviations versus the benchmark have been reduced modestly to ensure stock selection is the key driver of relative
performance, although the strategy remains skewed away from sectors trading at substantial premium to their historical valuation ranges.
While markets may gyrate on every comment from a major central banker, the direction of travel in global monetary policy is clear
as the debate now revolves around the timing and pace of rate hikes and balance sheet normalization. Ultra-low interest rates and
quantitative easing have distorted the valuations of a variety of assets, boosting the price of defensive, bond-like equities while depressing
the valuation of cyclicals and businesses where the medium-term outlook for profitability is difficult to predict. As nontraditional
monetary policy comes to an end, we would expect the relative valuations of different parts of the global equity market to return to
historical norms. Valuation focused strategies have struggled during this period of artificially low rates but the market rotation during
the second half of 2016 showed how violently markets can shift on any sign that the current sluggish, low rate environment could end.
Valuation focused strategies have generated substantial value in the equity market over the long term and we feel they are well positioned
for a new environment of more traditional monetary policy.
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset
Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which
are informed by a robust exchange of ideas throughout the firm.
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Published on 11 July 2017.
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