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Overheating US is biggest risk to stocks, says Pru

Tight labour market and tax cuts in world's largest economy present the biggest risk to 'frothy' stock markets in 2018, says Prudential.

Overheating US is biggest risk to stocks, says Pru

The key risk to ‘frothy’ stock markets this year will be an overheating in the US caused by a combination of a tight labour market and tax cuts, according to insurance giant Prudential.

David Shairp, head of research at Prudential Portfolio Management Group (PPMG), which is responsible for running around £180 billion in 'multi-asset' funds for the insurer's clients, said stock markets were well positioned in 2018, provided companies delivered on earnings expectations.

He said the case for global equities ‘remains constructive’, especially after the business cycle accelerated in the second half of last year leading to earnings upgrades.

'They key message for this year is equity market prospects are based on delivery of those earnings,’ he said.  

‘If the earnings come through then equities can do fine. It is if earnings falter that is the key risk.’

He said earnings would suffer should the economy ‘overheat in this strong cycle’. The tight labour market, with record low levels of unemployment, could push up wages, which increases costs for companies and hits their margins and ‘reverses the earnings gains’.

Leila Butt, senior economist at PPMG said the US was the region where overheating was the biggest risk and where it would likely happen first, given president Donald Trump's package of tax cuts.

‘The labour market is extremely tight and there is fiscal loosening… creating scope for an unexpected wage hike,’ she said.

Anthony Willis, investment manager at BMO Global Asset Management, is also cautious on the US. The group's multi-manager portfolios are underweight the US, with Willis arguing stocks in the world's largest economy were trading on high valuations, while 'other parts of the world offer better value'.

‘Given the economic backdrop, the US could well be set for a decent year, though the newsflow will have to continue to be strong to push markets onwards to yet more record highs,’ he added.

Shairp said global stock markets were in a ‘maturing’ cycle, trading on 17 times earnings which he argued was ‘richly priced’.

‘Financial assets are not cheap but we still have a bias to equities despite the short-term frothiness and we are focusing on the later equity cycle,’ he said, adding that emerging markets, Japan and Europe were still providing some value for investors.

Europe: cautious optimism

Shairp said the eurozone was in a ‘mid-stage cycle’ and would continue to enjoy a cyclical recovery while emerging markets were expected to ‘grow relatively solidly’.

But Willis was more circumspect on Europe. He said BMO's multi-manager funds were 'neutral' on the region, running allocations roughly in line with their benchmarks, with renewed growth likely to be challenged by the strong euro's impact on exports and a tapering of central bank stimulus.

Chris Godding, chief investment officer at investment group Tilney, agreed on the threat to European markets from central bank policy.

‘The European Central Bank has said it will pursue a cautious and accommodative stance in 2018 but that does not mean it cannot change its mind,’ he said.

‘Monetary policy in Europe is not appropriate for the growth levels we are seeing and it needs to be tightened.’

He was more pessimistic on the UK, where BMO is underweight despite the relative cheapness of stocks.

‘The UK will struggle under the cloud of uncertainty caused by Brexit, though as the year unfolds, more clarity is likely on the key issues around trade and this will help firms determine their longer-term plans,’ he said.

‘There are plenty of opportunities for stock picking managers but with both economic and political headwinds, we currently favour other regions.'

Emerging markets backed

Willis also backed emerging markets to continue delivering after two years of outperforming broader global markets.

He said BMO's funds had benefited from an overweight to developing economies over the last year, adding that 'we still believe there is relative value from equities in the region'.

Godding agreed, arguing that despite their rally, emerging market stocks were still cheap.

‘Emerging markets are still below average valuation levels,’ he said. ‘We are positive about emerging markets and with the global recovery, it seems to be a higher beta area to focus on.'

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