2017 Mid-year Global Market Outlook: Broader Growth, Narrower Risks

Global stocks may continue to rise in the second half of the year as long as earnings growth continues—although periods of pullbacks are expected and healthy in a long-term bull market. This outlook is supported by broad global economic growth and receding political risks. The factors that that led to outperformance by international stocks in the first half of the year may ease in the second half of the year.

Broad economic growth

The global economy is having one of its best years in more than half a decade. All of the world's top 20 economies are growing so far this year, a broadening of growth we haven't seen since 2010, and that is boosting growth in emerging market economies as they export more.

Economic growth highlights from Europe, Asia and Latin America:

• Europe has posted a solid pace of growth so far this year, and while we don't have the second quarter GDP number yet, the Eurozone outgrew the United States in the first quarter, as it has most quarters during the past couple of years. Economic surveys in Europe continue to rise to near past peaks and may ease in the second half of the year, but Europe’s economic data reveal steady growth that is likely to be maintained, as can be seen in the pace of retail sales, industrial production, and job growth.

• In Asia, recession-prone Japan has put together the longest run of economic growth in more than a decade. The second quarter is likely to mark the sixth consecutive quarter of growth for Japan's economy, a welcome break from the three recessions over the past 10 years. Elsewhere in Asia, China's economy slowed in the second quarter as they braced for rate hikes by the Fed, but that was after a strong start to the year.

• In Latin America, Brazil’s political climate remains chaotic and threatens to return the economy to recession. But, in Mexico the outlook has improved, demonstrated by the peso this year fully recouping the more than 15% drop that followed last year’s U.S. election.

Leading indicators of global economic growth, such as the Organization for Economic Cooperation and Development's Index of Leading Economic Indicators for the world's economies continues to rise, pointing to sustained global growth in the second half of the year.

Receding risks to growth

The populist political and trade risks that loomed at the beginning of the year have mostly faded as protectionist rhetoric has cooled and European election outcomes eased worries over a breakup of the Eurozone. Most encouragingly, world trade is on track to post the best growth since 2010 as we head into the second half of the year. This is important since the companies in the MSCI AC World Index get more than half of their revenues from international trade.

One risk hasn't receded this year: the United Kingdom's exit from the European Union, or Brexit. However, markets have recognized that Brexit is a slow moving risk with a long period of negotiations just beginning. The stakes for the U.K. are high and that is reflected in the yield spreads. Historically, stock market peaks are usually signaled by the spread between long and short-term interest rates ahead of a recession and accompanying downturn in corporate profits. Examining yield spreads from around the world, they show that the risk of recession is currently modest—except for the U.K. where the Brexit-related uncertainly has about a 60% chance of tipping the U.K. economy into recession in the coming year based on the history of U.K. yield spreads and recessions since 1970. Despite financial linkages, broader global growth should help to keep the risks largely contained to the U.K. economy.

International stock outperformance

Better economic growth isn't why international developed market stocks outperformed U.S. stocks in the first half of the year. Instead that has all been due to the weaker dollar—where politics have had an impact on markets this year. The drop in the dollar in the first half of the year boosted the MSCI EAFE Index by 5%. If we strip out the gains from the drop in the dollar and look at relative performance in local currencies, international stocks actually lagged U.S. stocks despite better economic growth.

Relative stock market performance is usually driven more by the performance of sectors that dominate a country’s stock market, rather than the country's GDP growth. This year, the technology sector has led world markets higher and the U.S. stock market has much more exposure to the technology sector than do the rest of the world's markets. In the second half of this year, economic growth should remain solid in the world’s developed markets. But, if the dollar stabilizes and the technology sector continues to lead the market, we may not see the same outperformance by international stocks we saw in the first half of the year.

After the 17% gain in the MSCI Emerging Markets Index through June 25, it is worth keeping in mind that EM stocks have experienced several 17% or greater rallies in each of the past few years only to give those gains back again. But unlike in past rallies, this year’s EM outperformance has been supported by all four key drivers:

1. stronger developed country demand,
2. solid growth in emerging market economies,
3. a break from the long decline in commodity prices (excluding oil),
4. a weaker U.S. dollar.

While there are risks to these drivers in the second half of the year, the breadth of drivers makes EM less vulnerable to giving up these gains than in recent years when they were less well supported.

Risks to global stocks

Rather than a geopolitical event, the biggest risk to stock market performance is likely an easing of the expectations for economic and earnings growth that have been supporting stocks' above-average valuations. While the price-to-earnings ratio for global companies has risen to near 15-year highs, this year's broader global economic growth has lifted earnings per share and kept the price-to-earnings ratio for the MSCI All Country World Index below the 2015 peak even as global stock prices have hit record highs.

While valuations of stock markets around the world are collectively near 15-year highs, they vary widely. Making valuation comparisons across markets can be challenging. The price-to-earnings ratio (PE), which divides price by the earnings over the trailing twelve months, is probably the most well-known and oldest of valuation measures. Comparing the U.S. stock market to that of Japan presents a stark contrast. With the MSCI USA Index PE of 21 and MSCI Japan Index PE of 14, it appears Japan offers investors a relative bargain compared to the United States.

Appearances can be misleading since stock markets of different countries tend to be valued similarly to the different sector(s) that drive their performance, as you can see in the charts below.

• Since the U.S. behaves like technology it isn't surprising that the MSCI USA Index is valued like the MSCI World Information Technology Index which has a similar PE of 23.
• Likewise, the MSCI Japan Index performs like and is valued like the MSCI World Financials index which has a similar PE of 14.
• We can also see this looking at the Eurozone which is composed of 19 European countries (with a PE of 18 for the MSCI Euro Index) and tends to perform like—and is valued just like—a combination of three different world sectors: financials, telecommunications and materials.
• Finally, Australia performs like industries in the world materials sector (chemicals along with metals and mining) and the MSCI Australia Index has a PE of 15, similar to the weighted combination of those industries.

The valuation differentials between sectors and across different countries are currently not far from their 20-year averages, suggesting relative valuations do not currently support a compelling reason to favor one country's stock market over another when seeking value.

Interestingly, for the first time ever, the "cash" in portfolios has actually been more volatile than stocks. The dollar, the pound and the yen have been all more volatile on a daily basis than their country’s stock markets, as you can see in the chart below for the U.S..

Some investors may see this as a worrisome sign for the second half of the year as they fear that stocks market participants have gotten complacent about better growth. But it is comforting to know that while it is true that global stock market volatility is low, that hasn’t been a leading indicator of declines in the past.

Interestingly, currencies continue to absorb the impact of political and policy developments while stocks remain tightly connected to earnings, serving as a reminder about staying focused on what matters and also the currency risk in international investing.