The prospect of a global trade war started by the US might have dominated investor attention at the start of 2018 but no-one should take their eye off what’s going on at the world’s central banks, says Invesco Perpetual’s Nick Mustoe.
After the reappearance of volatility at the beginning of this year, it seems that global equity markets have returned to normal following a calm 2017 that saw many stock markets reach new record highs.
Coming into the second quarter of 2018, Invesco Perpetual chief investment officer Mustoe believes that the biggest challenge equity markets will face is central bank policy change.
Performance of indices over 2018
Source: FE Analytics
He said: “The market is currently pre-occupied with the ongoing tariff war between the US and China, but I think the bigger potential challenge is the long-term shift in monetary policy in the US and UK.”
The Federal Reserve has been raising interest rates since 2015 and most recently in March this year when it increased rates to 1.75 per cent. Some also expect the Bank of England to raise interest rates this month from 0.5 per cent to 0.75 per cent.
While the European Central Bank is yet to follow suit, many believe it is only a matter of time as the global economy embarks on a synchronous policy of monetary tightening.
Mustoe said: “Everyone has been so used to the accommodative stance of the past 10 years and markets have become anchored around low interest rates. I think that this change in policy will lead to higher long-term interest rates and a shift in sectors that perform in that changing environment.”
The shift in sectors Mustoe referred to is from overvalued to undervalued sectors and he sees this as an opportunity to pick up some bargains.
He said: “There are significant valuation disparities between momentum-driven equities, such as the tech sector and stocks which exhibit dependable growth, compared to areas which have lagged, such as the oil sector and cyclical sectors. We see momentum-driven equities as overvalued.
“The chart below from Citigroup looks at US sector valuations, for example. It shows sector valuations on price/book measure versus history. A value below zero shows a sector is cheap compared to its own history. A value above two shows that a sector is over two standard deviations more expensive than its history.
“As you can see tech-related areas are amongst the most expensive and energy is one of the cheapest sectors in the US market on this analysis.”
US equity sector valuations
Source: Invesco Perpetual
Elsewhere, Invesco’s Mustoe sees opportunities for equity markets in Europe and the UK.
“After a long rehabilitation, Europe, post the financial crisis, is now firmly back on track. This is thanks to a steady improvement in private consumption and (more recently) investment. Banks are lending again and unemployment is falling,” he said.
“The extended Brexit negotiations have caused global investors to shun the UK equity market amid negative sentiment from the media and economists. This is now clearly reflected in valuations, which are cheap.
“Many good quality companies offer strong dividend yields, with the realistic expectation that those dividends will grow. In my view, the Brexit process has created a considerable opportunity in the UK equity market against an increasingly bearish backdrop.”