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Caution urged against backdrop of US tech boom, tax cuts

Dan Kemp  |  10 Jul 2018Text size  Decrease  Increase  |  
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It’s undoubtedly been an interesting time for global investment markets. Following a strong 2017 for many growth assets, 2018 has seen a return to more challenging conditions. Confirmation of the continued upward path for interest rates in the United States, combined with escalating trade tensions and potential geopolitical threats has resulted in volatility not seen since early 2016.

In addition, we’ve faced ongoing Brexit negotiations and concerns over the political outlook in Italy, which at its heart, questions the sustainability of the Eurozone. This comes just as the European Central Bank slows its stimulus program, ensuring there is no shortage of uncertainty to be navigated by investors.

Against this backdrop, equity markets have, nonetheless, managed to post impressive medium-term returns. Emerging markets have borne the brunt of the recent volatility yet have still delivered double digit gains over the last twelve months. Returns from Japanese and US equities over the past twelve months have also been strong, especially the technology sector, with US investors further buoyed by corporate tax rate cuts and solid earnings results.

expectations of investment returns across asset classes for the next 10 years

Changes in interest rate and inflation expectations have generally resulted in much more muted returns from key defensive assets like government bonds and other interest rate sensitive asset classes including listed property and listed infrastructure, with the latter experiencing significant volatility.

We reiterate our perpetual message that it's incredibly hard to know how the economic and political events around the world will play out. We are especially sceptical of anyone trying to position for these events in advance as it rarely adds value to portfolio returns. The bigger opportunity, to our way of thinking, is to assess valuations in both equity and bond markets in a world where investor sentiment appears complacent.

In undertaking this analysis, we can see disparate expected returns across the investment universe, offering an opportunity to reduce the risk of loss as major markets return to what they are worth, over time. It's difficult to predict the timing and catalyst for any strength or weakness, of course, and while we are not forecasting some imminent or catastrophic decline, we need to be prudently positioned and ensure we remain fundamentally diversified.

US due to deliver worst equity returns globally

Positive sentiment continues to surround the outlook for U.S. growth, with a booming technology sector and corporate tax rate cuts influencing demand. This has exacerbated our cautious stance, with the asset class now offering negligible expected returns after inflation, on our valuation analysis.

While acknowledging the structural improvement in fundamentals brought about by the lower corporate tax rate, we believe that much of the good news relating to the strengthening US economy is now more than priced into the market, with U.S. shares now trading well ahead of our fair value estimates. This sees an elevated risk of a permanent loss of capital from these levels.

An exception to this is the U.S. healthcare sector which has been plagued by uncertainty over the outlook for healthcare regulation, given the Trump administration’s attempts to repeal Obamacare and reform pharmaceutical drug pricing policy.

While delays and a softening of this agenda have tempered negative sentiment, resulting in a strong start for the sector in 2018, a valuation opportunity nonetheless remains. Further, the majority of companies that make up the US healthcare index, by market capitalisation, such as Johnson & Johnson, Pfizer and Bristol-Myers Squibb, are "wide" or "narrow" moat-rated by Morningstar Equity Research, which we believe may highlight the sustainability of earnings in the sector.

is chief investment officer, Morningstar Investment Management EMEA.

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