Reflation is going global. The signs include a rebound in inflation expectations, a bottoming out in core inflation and wages, and a synchronised pick-up in economic activity indicators and corporate earnings estimates.
Markets are catching up to these fast-changing dynamics. A synchronised global recovery in corporate earnings is supporting equities. This is not only about reflation. Cost discipline (resources), hopes for regulatory easing (financials) and innovation (tech) are all contributing to strong 2017 earnings expectations. Earnings momentum is particularly strong in Japan and emerging markets (EMs), while solid in Europe. See the chart below. This underpins our preference for non-US equities at this time.
Changes in corporate profit estimates, 2012-2017
Sources: BlackRock Investment Institute, MSCI and Thomson Reuters, March 2017.
Notes: The lines show the three-month change in the aggregate 12-month forward earnings estimates. The data arebased on the MSCI U.S., EMU, Japan and EM indexes.
We believe the reflation trade — overweighting cyclical equities — has room to run, especially outside the US. We see global yields rising further but within limits: the US Federal Reserve (Fed) is likely to raise interest rates only gradually, and structural dynamics such as ageing populations keep us in a low-return world. We believe investors need to go beyond broad equity and bond exposures to diversify portfolios in this environment, and include factor-based allocations and alternatives.
Sharp increases in sentiment-based indicators may fail to translate into hard data such as corporate investment. In the US, the anti-growth part of President Donald Trump's agenda (protectionism) could win out over the pro-growth part (deregulation and tax cuts). Any shift of expectations towards a faster pace of Fed rate rises could spook markets. We see upside risk in Europe, where we do not expect elections to deliver the populist outcomes that markets have been fearing.
We prefer equities over fixed income, and selected credit over government bonds. We like European and Japanese stocks amid strong global growth. We see value shares such as financials benefiting from rising yields. We are neutral on US shares because of lofty valuations and the risk that expectations for tax reform and deregulation may be too high. We like EM equities on reform progress in countries such as India and our view that near-term risks to China's growth are overstated. In fixed income, we prefer higher-quality corporate bonds and selected EM debt.