Non-US Markets Look Poised to Stand Out in 2018Dec 1, 2017

2018 OUTLOOK: “Despite robust global economic growth, we anticipate greater uncertainty in 2018 as central bank policy begins to tighten. We see better opportunities outside the United States, with emerging-market technology and consumer names particularly interesting areas.”

We expect 2018 to be a potentially pivotal year for global equity markets. The global economy should continue to hum along, with both developed and emerging markets maintaining their momentum. However, we expect the era of cheap money will slowly draw to a close, bringing with it new uncertainties. Global equity markets broadly appear to be pricing in significant earnings growth, but we believe some regions such as Europe and Asian emerging markets were more attractively valued than their US counterparts as of late 2017, making it increasingly important for investors to focus on individual company fundamentals.

A “Goldilocks” Macroeconomic Scenario

The synchronized expansion we have seen around the world over the course of 2017 looks set to continue unimpeded in 2018. After being narrowly driven by a few countries like the United States and China, we have seen the expansion broaden out, with greater participation from Europe, Japan and various emerging markets, suggesting to us that the cycle has further to run. Still ample liquidity, potentially more supportive fiscal policy in a number of major economies and easing lending conditions should all help underpin global growth over the course of the coming year. Inflationary pressures have remained subdued, but we think they should pick up as the recovery advances.

With this more durable economic recovery has come a simultaneous move by certain central banks to begin to tighten monetary policy. We see two reasons for this. First, economic conditions have improved in a number of regions to the point that tighter policy is warranted. Second, we believe central banks need to begin to give themselves greater leeway to act in the future to provide stimulus should economic growth weaken over the medium term.

With the recovery in the United States the most entrenched, the US Federal Reserve (Fed) is already farthest down the path toward policy normalization. We anticipate a gradual rise in interest rates over the year, along with a continued unwinding of the Fed’s massive balance sheet as the economic recovery continues and the labor market remains relatively tight. In Europe, policy is likely to tighten more gradually as the recovery builds steam and inflationary pressures remain subdued.

Although the effects of these moves will bear watching, we would point out that central bank-driven liquidity remains significant and should continue to buttress global growth. The balance sheets at the European Central Bank (ECB) and Bank of Japan are bigger than the Fed’s as a percentage of gross domestic product (GDP) and should continue to support global equities. So long as rate hikes and policy changes are gradual and well communicated, we believe markets can take the moves in stride. Even emerging markets need not necessarily fear tighter Fed policy and a potentially stronger US dollar so long as the dollar moves steadily. We believe the positive economic forces currently present in the global economy will remain strong enough to overcome the potentially negative impact tighter policy will have, but we could see some short-term volatility as markets adjust.

Better Opportunities outside the United States

Corporate earnings and relative valuations also to some degree have mirrored where the major economies are in their recoveries as of November 2017. And we believe positive economic and earnings visibility has been behind equity market returns during 2017, a trend that can continue in 2018 so long as earnings growth maintains momentum. US earnings have recovered strongly and are now past their prior peaks, but with corporate earnings beginning to show increasing strength outside the United States, we believe an opportunity exists for those stock markets to lead global equities over the coming year. Additionally, market correlations have declined substantially, creating greater opportunity to differentiate between markets and focus on individual stock selection.

Falling Market Correlations May Create More Individual Opportunities

One-Year Rolling Correlation in Weekly Price Change of 45 Markets against the MSCI All Country World Index
As of November 3, 2017

Source: Calculations by Franklin Templeton’s Global Research Library using data sourced from FactSet and MSCI. R-squared is a measurement of how closely the price change correlates with the performance of a benchmark index and is a measurement of what portion of its performance can be explained by the performance of the overall market or index. Values for r-squared range from 0 to 1, where 0 indicates no correlation and 1 indicates perfect correlation. Past performance does not guarantee future results.

In Europe, we expect earnings to recover alongside a pickup in inflation over time. Modestly higher interest rates can benefit earnings in the financials sector, while rising commodity prices would tend to benefit energy and materials companies. We do remain somewhat cautious on the broader developed markets in general, however, as equities may be “priced to perfection”—any disappointment in earnings or rapid increase in interest rates could prove disruptive. In Europe and Japan, equity valuations as of October 2017 were still below their post-crisis peak in 2015, though close to their long-term historical averages.

In Asia, we expect strong economic growth in China and India to feed through to better corporate profits across the region. Already, we are seeing many emerging markets trade more on corporate and sector fundamentals than on broader macroeconomic trends, something we anticipate should continue in 2018. Furthermore, China’s emphasis on consumption over government investment and India’s ongoing structural reform efforts may create conditions for continued economic and corporate earnings growth over both the short and longer terms.

Emerging-Market Equity Valuations Have Risen, but Have Been Higher in the Past

Emerging Markets Relative to Developed Markets: Price-to-Earnings
As of October 31, 2017

Source: FactSet, MSCI. Emerging markets are represented by the MSCI Emerging Markets Index, and developed markets are represented by the MSCI World Index. Data as of 10/31/17. Past performance does not guarantee future results.

Growth in Disruptive Companies

In this environment of modestly rising interest rates and fuller valuations, we believe innovative companies with the potential to disrupt existing industries, including in emerging markets, could fare particularly well. We see opportunity not only in disruptive technology companies, but also in companies that are using technology to change entire industries. And unlike during past runs in technology stocks, many of these companies have actual earnings and cash flows that can support reinvestment in their businesses, which in turn makes them less reliant on raising capital in the markets at a time when interest rates are climbing.

Emerging markets are particularly attractive to us in this regard. We are at a tipping point in many emerging markets where resources and exports are no longer the primary drivers of growth and of the equity markets. Technology companies now make up a sizable portion of emerging-market stock markets, and these companies have the opportunity to drastically improve economic productivity through things like mobile banking that are hard to replicate in developed economies. The rising middle class should also continue to foster these trends. Emerging-market consumers are not only demanding goods, but also services such as banking, health care and entertainment.

These technological advances and rising consumption should also help reinforce the ongoing structural trends we are seeing in China, India, Indonesia, the Philippines and elsewhere. As growth improves and access to technology increases, we see the rise of urbanization and the burgeoning middle classes consuming more products, further driving growth over the longer term.

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We see better opportunities outside the United States, with emerging-market technology and consumer names particularly interesting areas.