Where do potential returns compensate for risk?
With the world’s eyes on political ruptures in the West, could opportunities be opening in the East?
Despite the shroud of political uncertainty, the macroeconomic backdrop is expected to be broadly supportive of equities. However, in the US and Europe, equity risk premiums – the excess returns expected above sovereign bond yields – have fallen to multi-year lows. Is there a large enough cushion to protect against policy uncertainty?
US economic data is strengthening and the outlook for reasonably priced stocks appears compelling; however, president Donald Trump failed to pass his proposed Obamacare reforms, and plans to boost infrastructure spending have already slipped into next year. A package of tax cuts is expected in the second half of this year and any delay could be viewed negatively.
Similarly, European economic data shows improvement in the major economies and a better outlook for growth, while political risks lurk in the background. The continent is entering a busy period of elections and a shock result in France or Germany could derail the bloc’s economic recovery. Valuations here are not cheap on a historical basis, and stocks offer little protection against disappointing earnings growth.
The UK is not immune to politics either: Brexit negotiations will continue to dominate headlines for the next two years. However, UK equity risk premiums have not fallen to the same extent as the US and Europe. Investors may have discounted forward-looking earnings too keenly, meaning the UK could offer some value on a relative basis to global equities.
At a sector level, the impact of higher inflation, driven in part by the pound falling roughly 15% since the Brexit vote, is hitting consumer-facing sectors. Businesses with pricing power should be in the strongest position. Despite the potentially negative impact of inflation on consumer spending and weak business investment, consensus growth estimates for the UK are now higher than the pessimistic forecasts from last year. Still, the growth rate is forecast to trend downwards over the next few years.
In Japan, politics has fallen off investors’ radars, but prime minister Shinzo Abe’s dogged ‘third arrow’ of reform is continuing. Slowly but steadily, the government is implementing much-needed business reforms that should help boost the nation’s stagnant consumption and growth.
There are several reasons to be positive about Japanese equities. Improvements in corporate governance have the potential to dramatically improve returns on equity, which should lead to greater dividends and buybacks. Many Japanese businesses have become more globally competitive due to a fall in the yen against the dollar since the US election. This tailwind should continue as the US Federal Reserve continues to raise interest rates and the Bank of Japan remains ultra-accommodative with its monetary policy.
If inflation continues to rise, there is the potential for a massive increase in demand for shares from Japanese pension funds and households. Also, Japanese equity valuations remain lower than the rest of the developed world when you look at the equity risk premium – the reward you get for the risk you take on.
Japan remains an interesting long-term investment story and offers a degree of diversification from other developed markets.
Elizabeth Savage is Rathbones' head of research.