Financial markets are sending conflicting messages. Record highs for U.S. equities and muted volatility are at odds with typical risk-off signals such as tumbling EM currencies, weakness in industrial commodity prices and strength in defensive stocks. Why? We see a dissonance, with rising macro uncertainty and gradually tightening financial conditions set alongside still strong economic and earnings growth.
Investors returning from summer breaks face mixed messages from markets. The chart above shows 2018 performance for selected asset classes year-to-date (orange dot) and as of May 31 (blue dot), before the latest EM swoon. U.S. equities have marched higher since summer’s start, propelled by another quarter of solid sales and profit growth. 83% of U.S. firms beat second-quarter earnings estimates. Broad-based, robust sales growth shows the profit boost came from solid demand and not just tax cuts. Yet global minimum volatility equities have rebounded, typically a sign that investors are looking for safety. We believe investors are seeking resilience as they adjust to heightened economic uncertainty and moderately tighter financial conditions, partly reflecting rising trade tensions and a firmer U.S. dollar.
We see two dynamics driving markets today. First, U.S. fiscal stimulus and trade tensions have stoked higher macro uncertainty on the upside and downside. Second, a rise in U.S. short-term interest rates has gradually tightened financial conditions. Competition for capital from cash-like assets has pushed up the compensation investors demand for risk. This has hit areas with weak fundamentals or political uncertainties and beyond: Global equity valuations have fallen to 14.8 times forward earnings, below their long-term average.
Our BlackRock GPS points to sustained above-trend global growth. We see increasing scope for upside surprises in the U.S. as consensus expectations for growth have taken a hit amid rising trade tensions. A third of the industry-wide inflows into U.S.-listed fixed income exchange-traded products (ETPs) over the past three months has gone into ETPs holding short-term debt, according to Markit. Markets with stronger fundamentals, such as U.S. equities, have also benefited: U.S. equity funds have pulled in $10.4 billion since May even as global equity funds as a whole bled money, EPFR data shows.
A string of rolling market shocks this year did not snowball into something more systemic. We believe this was due to ongoing support from strong economic growth. Yet an uneasy equilibrium prevails. The longer macro uncertainty persists, the greater the risk of waning business confidence undermining investment spending. Risk assets are already pricing in significant downside, in our view. Any signs of declining uncertainty could spur a swift rally in risk assets such as EM equities, as prices catch up with strong earnings growth.
We expect the outlook to remain murky in the short-term. There are few indications that the U.S. and China are close to a reconciliation on trade disputes. We do not see either side willing to compromise. This warrants a focus on portfolio resilience. Bottom line: Strong earnings growth, particularly in the U.S., underpins our preference for equities over debt. We still like the momentum factor, along with a tilt toward quality for resilience. We believe fixed income investors should focus on shorter duration and higher-quality credit. See our global investment outlook, and read more market insights in our Weekly commentary.