As the US and UK continue to enjoy steady growth, Europe still lags behind
The US economy continues to grow rapidly. Employment growth indicates that companies are likely to hire. However, inflation is becoming more of a concern as commodity prices, especially oil, wages and housing costs are on the rise. More positively, business confidence has significantly improved accompanied by increases in manufacturing output, capacity utilisation and export growth. Additionally, corporate earnings have risen strongly and analysts continue to upgrade their estimates. While higher interest rates, increasing geopolitical fears, weaker growth in China and approaching US elections lowered the level of visibility for the equity market, investors are aware of most of the potential negative factors. Consequently, we are more likely to see positive than negative surprises.
The UK interest rate cycle is more advanced than those of other countries. Further rate rises cannot be ruled out. The UK economy is very sensitive to short rates, through the mortgage market and indebted consumers: any retrenchment by consumers would be negative for the whole economy. While the market shows signs of value, its bias toward defensive sectors reduces its attractiveness. Sterling's strength has helped the UK's relative performance but has contributed to a poorer profits position due to the high proportion of dollar-related profits earned by companies in the market. While rising taxes could hinder the UK's long-term growth, in the medium term a mitigating factor would be the large proportion of the market in the oil and resource sectors.
Signs of a broad and sustainable European economic recovery have yet to emerge. Consumer activity remains weak: high levels of unemployment could continue to affect consumer confidence in the medium term. More positively, strong consumer balance sheets and high savings rates could support a consumer-led recovery. At a micro-economic level, low expectations regarding corporate earnings and the possibility of an economic growth pick-up following the US cycle could create positive surprises and signal a more encouraging outlook for European companies.
Economic news has been very strong especially regarding GDP, wages, consumer confidence and exports. Furthermore, positive signs of improvement within Japan, which is essential for a secular recovery, have emerged. At a micro level, a pick-up in economic growth is likely to be very positive for Japanese companies which have cut costs. Indeed any increase in revenues feeds through to profits. Additionally, market valuation, profit growth momentum, liquidity and the global economic cycle all support the Japanese market's outperformance.
Equities fell along with other asset classes in the last quarter. However, Asia has not participated in the recovery and this might be a warning sign on the long term. Asia tends to underperform when US rates rise and also when growth rates slow. There are many foreign investors with an overweight exposure to Asia, and so far redemptions remain limited.
Anne-Sophie Girault, senior portfolio strategist, Fidelity Investments
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