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What next for markets?

Rob Morgan
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A round up of current Charles Stanley views on markets. (Source: Shutterstock)

Italian troubles in Europe

Recent political developments in Italy have presented additional risks for markets, especially European equities. Populist parties with anti-euro and anti-EU policies have formed a government meaning Italy is likely to want to spend more, tax less and increase the budget deficit by more than the European Central Bank (ECB) and its partners will like.

We believe there should be an eventual solution to the dispute between the Italian political parties commanding a majority and the Eurozone, but it could take time and cause friction. The ECB will have to decide how far it will go in accommodating these actions, and the Eurozone leaders will have to try to negotiate a settlement with Italy that manages to compromise between the political aims of the elected parties, and the rules of the single currency.

A dispute is likely to cause stresses for Italian banks, which need liquidity from the ECB and for the Italian state itself as it seeks to borrow more money. Given the way views are firmly entrenched on both sides there is scope for things to escalate. Already there has been a slowdown in the pace of earnings and dividend growth among European companies this year, but now political risk has increased markedly. This potentially hampers the area further in terms of investment returns.

The US powers on

Overall, we feel the market’s growth expectations for the US are a little pessimistic. As well as corporate tax cuts, there is likely to be extra government spending, particularly on defence. Elsewhere, it is also the first year of repatriation of cash held abroad, which is likely to result in extra capital investment, share buybacks and potential wage increases. Deregulation in the bank and energy sectors is also positive for growth.

Risks to the share markets include the continuing trade disputes between the US, China and the EU. The expectation is that there will be a deal between President Trump and the Chinese authorities this year before the US mid-term elections. China is likely to offer some more market openings for US firms, and some lower tariffs, to enable Mr Trump to claim a win. It is also likely the US will push harder on Germany and the EU, especially over the differential tariffs on car exports where there is a tariff four times as high into the EU as into the US. Any toughening of US pressure on the EU is a further negative for Eurozone shares.

There is likely to be regulatory and tax moves against the successful technology giants, but whilst governments try to find ways to tackle them they should continue to grow quickly in our view, disrupting the business models of many more traditional firms. Overall we remain positive on the prospects for US equities and believe markets can advance from current levels during the remainder of the year. We do not think current valuations are unreasonable given the dynamism of the US market and the balance of sectors in which faster growing areas such as technology are important constituents.

UK uncertainty lingers

We believe UK shares are relatively cheap and under-owned by global investors. The UK economy continues to generate more employment and incomes are now rising faster than inflation, which is positive for consumer sectors. The uncertainty of Brexit will likely mean volatility and the movement of the pound in currency markets will continue to be an important factor. Sterling weakness tends to boost the value of large companies who earn much of their income overseas in other currencies, but strength in the currency implies pressure on such shares.

A positive outlook for Asia and emerging markets

We believe valuations are generally attractive across emerging markets with strong economic and company earnings growth expected. The recovery in commodity prices should also support a continuation of improving economic data.

There is the potential for volatility given US impatience with China in particular. If President Trump embarks on a trade war with China, this could affect the wider region negatively. President Xi’s move to cement his position as president for life will make pragmatic reform more difficult.

As the Bank of Japan continues with a loose monetary policy at a time of US tightening we expect to see further weakness in the yen. Coupled with corporate reform and relatively low valuations ascribed to Japanese shares it could mean further gains.

Bond returns limited

We anticipate three further interest rate rises in the US over the next year, broadly in line with market expectations, but do not expect much if any action on rates in the Eurozone or the UK. We feel inflation is not going to be a major issue for investors. We see major economies undershooting inflation targets for some time to come, implying there will be no rapid withdrawal of stimulus measures by central banks.

Bonds are sensitive to changes in inflation and interest rates. Broadly speaking as inflation and interest rates expectations rise bonds fall in value. This is in order that the fixed income they pay to investors reflects the prevailing conditions as well as the level of risk of the issuer. The above scenario implies benign conditions for the asset class.

Despite this, valuations look relatively unattractive at present. In addition, the reduction in US government debt purchases by the Federal Reserve, at a time when net foreign purchases have declined, could lead to lower demand and higher yields. Our preference is for certain areas of high yield and emerging market debt but, overall, we believe the asset class offers limited scope for returns.

This article is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investors should be aware that past performance is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. If you are unsure of the suitability of your investment please seek professional advice.

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