Global risk assets continued to move higher in October, with world stocks reaching new all-time highs and corporate spreads continuing to tighten. Strong earnings and improving economic data are largely backing the bulk of the recent equity rally. Indeed, a majority of companies are beating Q3 earnings estimates in all of the regions, with the U.S. posting the largest number of “beats.” Interestingly, a large majority of U.S. companies are also revising upward their earnings guidance, which illustrates the strong earnings momentum at this stage of the cycle. The improvement in the underlying economy can also be highlighted by climbing economic surprise indices with the Citigroup’s U.S. economic surprise index recently reaching a new high since last April.
Our asset allocation still remains unchanged this month, with a neutral stance on equities. The significant upturn in earnings growth since the second half of 2016 is fast approaching a pause, with the year-over-year change in the U.S. coincident and leading economic indicators, the global net earnings revisions ratio and industrial production growth all weakening. Among the many different economic and financial indicators we regularly monitor to assess where we currently stand in the earnings cycle, the majority of them are now pointing to an imminent transition from an acceleration phase to decelerating earnings growth. Such a pause in profit growth acceleration historically tended to lead to a pick-up in market volatility. With equities trading at historically elevated valuation levels, a coming pause in earnings growth makes the equity market particularly vulnerable to disappointments. We also believe that inflation data will strengthen into year-end with the output gap in both the U.S. and Canada expected to close by the end of this year, our expectations for a rebound in oil prices and as a lagging effect to the recent pick-up in global manufacturing indices. Rising inflationary pressures into year-end presents a key risk for risky assets as higher inflation may drive price multiples lower. In spite of the fact that the global economic backdrop remains positive and that the global recovery remains well synchronized across regions, risks on the horizon threaten to derail investor optimism with the current tightening in financial conditions possibly weighting on risky assets and economic growth down the road.
Regional & Sector Allocation
There is no change to our regional allocation this month with our largest overweight remaining Canadian and emerging market equities. Canadian stocks remain historically cheap relative to U.S. equities and we continue to expect the global oil market to tighten in the coming quarters. This should continue to exert a positive influence on oil prices. Macroeconomic conditions also remain ideal for emerging markets, with low real rates, soft inflation measures, easy financial conditions and improving global trade. EM central banks also have room to ease monetary policy as the EM-DM real yield differential remains historically wide and there is less need to defend the currencies. Forward earnings for emerging markets are also on the rise relative to developed markets, which represents another tailwind for EM equities.
As for our sector allocation in Canada, we still advise clients to overweight the Industrials, Information Technology, Financials and Energy sectors. However, we are removing Telecommunication Services from our list of top overweight sectors as relative upward earnings revisions are deteriorating for the sector.
In the U.S., we still advise clients to overweight the Information Technology, Financials and Energy sectors. However, we are replacing the Health Care, Real Estate and Telecommunication Services by the Industrials and Materials sectors. As we remain confident that Washington will ultimately enact a tax reform, we are of the view that a lower corporate tax rate should lead to higher investment and capital expenditures, hence benefitting the Industrials sector. The Materials sector also ranks high in both our earnings and price momentum models, which historically coincided with sector outperformance.
Canadian Bond Allocation
The relentless search for yield, a more dovish than expected ECB, strong earnings and expectations of lower bond issuance due to tax reform all contributed to push yields tighter during the month. We maintain our neutral stance to corporate bonds this month as valuations is extremely rich and we are concerned that decelerating economic growth combined with an increase in borrowing yields could hurt corporate fundamentals and the relative performance of credit. With the output gap in both the U.S. and Canada expected to close by the end of this year, this should also exert downward pressure on the profit margin outlook as margins historically tend to peak soon after output gaps close. Corporate spreads could also widen as central banks start withdrawing monetary stimulus as past declines in central bank net asset purchases coincided with widening credit spreads.
