MARKET INSIGHTS Quarterly Perspectives - J.P. … Perspectives UK | Q4 2017 ... economic and...

Quarterly Perspectives UK | Q4 2017

THIS QUARTER’S THEMES

1 UK equities: Knowing what you don’t know

2 US in late cycle

3 European equities and the euro

4 Japan: Improving corporate governance

STRATEGISTS

Tilmann Galler, CFAExecutive DirectorGlobal Market Strategist

Vincent Juvyns Executive Director Global Market Strategist

Maria Paola Toschi Executive Director Global Market Strategist

Michael Bell, CFA Vice President Global Market Strategist

Nandini Ramakrishnan Associate Global Market Strategist

Jai Malhi AssociateMarket Analyst

Ambrose CroftonAnalystMarket Analyst

J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights.

Guide to the MarketsUK | |

MARKET INSIGHTS

Q4 2017 As of 30 September 2017

MARKET INSIGHTS

2 | QUARTERLY PERSPECTIVES | Q4 2017

1 UK equities: Knowing what you don’t know

The labour market is tight, but real wages are struggling

• The UK’s unemployment rate has fallen to just above 4%, which is the lowest since 1975. A tightening labour market is clearly beneficial for UK consumers.

• When unemployment is low, wage growth typically accelerates, but this has not been happening recently. In addition, because of the weak pound, inflation near 3% is wiping out the 2% nominal wage growth, resulting in negative real wage growth.

• With real wages shrinking, consumers have been saving less. A lower savings rate has been helpful for the economy in that retail sales and consumption in the UK held up better than they otherwise would have done in the months immediately after the fall in sterling. However, savings rates can only go so low and the recent decline has reduced the UK consumer’s ability to withstand any further economic shock.

5

GTM – UK |

-6

-4

-2

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'02 '04 '06 '08 '10 '12 '14 '16

UK unemployment

UK labour market and consumer dynamics

%

UK savings rate% of household disposable income

Source: (Left) Bloomberg, ONS, J.P. Morgan Asset Management. *Nominal wages include bonuses. (Top right) ONS, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) ONS, Thomson Reuters Datastream, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 30 September 2017.

Headline CPINominal wage growth*

Real wage growth

UK e

cono

my

5

% change year on yearReal wage growth

0

4

8

12

16

'72 '77 '82 '87 '92 '97 '02 '07 '12 '17

2

4

6

8

10

12

'71 '76 '81 '86 '91 '96 '01 '06 '11 '16

Source: Guide to the Markets – UK, page 5

OVERVIEW

• The need for the UK to achieve a transitional deal that will protect UK trade with Europe is mounting. Economic growth has already started to slow this year.

• Given the upside and downside risks to the UK economy and the unpredictable path of sterling, a neutral stance on UK equities seems sensible.

• While we do not have enough conviction to take large size or sector bets, active management at the stock level should still add value.

UK households are saving less of their disposable income.

MARKET INSIGHTS

J .P. MORGAN ASSET MANAGEMENT | 3

A mixed outlook for growth

• The UK economy is 60% consumption, which means the UK consumer is key for the nation’s economic prospects. Consumers tend to reduce spending if they aren’t feeling confident. We have already seen a sharp dip in consumer confidence, which could have a negative impact on more domestically orientated companies that rely on UK consumption.

• The UK economy is quite sensitive to the housing market. If house prices go up, consumers tend to feel more confident. In recent months, both the RICS survey of house prices and the growth rate of UK home prices have weakened.

• Of course, UK businesses have a large role to play in the economy as well. Investment intentions surveys for both manufacturing and services companies took a hit last year, but have since recovered. If these intentions translate into actions, then UK business investment could help to support growth. The Bank of England estimates that quarterly growth in business investment will contribute 0.5% to GDP growth over the next quarter.

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GTM – UK |

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Consumer confidence

UK growth monitor

Retail sales vs. consumer confidence% change year on year (LHS); Index level (RHS)

Manufacturing and services investment intentionsIndex level

RICS house price survey and house pricesIndex level (LHS); % change year on year (RHS)

Source: (Left) GFK, ONS, Thomson Reuters Datastream, J.P. Morgan Asset Management. Retail sales data is a three-month moving average. (Top right) Bank of England, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) Royal Institute of Chartered Surveyors, Nationwide Building Society, Thomson Reuters Datastream, J.P. Morgan Asset Management. Light grey columns in all charts indicate recession. Guide to the Markets - UK. Data as of 30 September 2017.

ServicesManufacturing

Retail sales

UK e

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6

RICS Housing survey

House prices

Recession

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'01 '03 '05 '07 '09 '11 '13 '15 '17

-20

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'92 '96 '00 '04 '08 '12 '16


MARKET INSIGHTS

A bounce back in investment intentions has been welcome.


MARKET INSIGHTS

High conviction on having low conviction

• Large-capitalisation multinational companies listed in the UK, the FTSE 100, source nearly 70% of their revenue from abroad, which means when sterling falls, these companies stock prices tend to rally. After the UK’s referendum on EU membership in June 2016, sterling fell dramatically and the FTSE 100 rallied, providing some of the best equity returns in local currency for 2016. The more domestically focused mid- and small-cap stocks should outperform if sterling rises. Essentially, if investors knew the path of sterling, this could inform their view on small- and mid-caps versus large caps.

• UK fund managers have had a large bias towards small- and mid-cap UK equities over the past few years, which has paid off handsomely. In fact, the average weight of an all-cap UK equity fund to the small- and mid-cap space is above 40%, whereas the benchmark weight of small- and mid-caps in the FTSE All Share is only about 20%. This means that the average UK equity fund is about 20% overweight to small- and mid-caps. At a time when so much uncertainty surrounds the domestic economy, this is a very large bet. As such, it probably makes sense to hold a small- and mid-cap weighting closer to the benchmark.

• A positive for investors in UK equities is the fact that UK companies pay high dividends. UK equity dividend yields are about 4% for the FTSE All Share. This is notably higher than the dividend yields on offer in the US, Japan and Europe.

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UK equities performance and drivers

Trade-weighted GBP and FTSE 250 / FTSE 100Index level, rebased to 100 in Jan 2016

FTSE 100 vs. FTSE 250Index level, rebased to 100 in Jan 1987

UK small & mid cap exposure*%

Source: (Left) FactSet, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Top right) FTSE, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) J.P. Morgan Asset Management. *Exposure to small & mid cap companies is the exposure of all UK funds excluding small & mid cap only funds. Guide to the Markets - UK. Data as of 30 September 2017.

Equi

ties

42

% of revenues from overseas

FTSE 100 67.5%FTSE 250 43.9%

Average fund manager exposure*

Weight of small & mid cap in FTSE All-Share

FTSE 250 / FTSE 100

GBP trade weighted

25th - 75th percentile range

FTSE 250

FTSE 100


INVESTMENT IMPLICATIONS

• The UK consumer and UK businesses face a murky outlook. Real wages are shrinking and Brexit will eventually pose challenges for certain industries and companies even if a transitional deal were to delay these challenges.

• Lack of clarity on the outlook for the economy and sterling means staying neutral on large versus small- and mid-caps probably makes sense. Within sectors, however, some companies will still be better poised to navigate through the uncertain outlook environment.

• Finding income from UK equities is a good way to dampen the volatility in potential price fluctuations.

Mid cap equities have rallied far more than large cap since the crisis, but can this continue?


OVERVIEW

• The US economy has entered late cycle, with the unemployment rate close to previous lows.

• Low unemployment and healthy economic growth have historically led to a rise in wages, core inflation and interest rates.

• Despite being late cycle, near-term recession risk remains quite low. Wages and interest rates probably have room to rise from low levels before they cause problems for companies and the economy.

US unemployment has fallen to 4.4%, close to previous cycle troughs.

MARKET INSIGHTS

2 US in late cycle

The US economy is now late cycle, but near-term recession risk remains low

• The unemployment rate in the US shows that the labour market is now in the late part of the economic cycle. Unemployment has rarely been at such low levels. Clearly, in the near term, this is good news for the US economy, supporting consumer confidence. However, it does raise the probability of a recession in the medium term (the next 2—4 years).

• The unemployment rate has recently fallen below estimates of full employment from both the US Federal Reserve (the Fed) and the Congressional Budget Office. This is the unemployment rate at which wage growth should theoretically start to accelerate, as workers’ bargaining power increases due to an erosion of labour market slack.

• In the past, the economic expansion has tended to last between 2—4 years after the point at which the unemployment rate has fallen below full employment. It is notable that despite very low unemployment, wage growth currently remains relatively low.

22

GTM – UK |US labour market

US unemployment rate and wage growth%, wage growth is year on year

Source: BEA, FactSet, J.P. Morgan Asset Management. Wage growth is average hourly earnings of total private production and non-supervisory employees.Guide to the Markets - UK. Data as of 30 September 2017.

Glob

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Unemployment

Wage growth

August 2017: 4.4%

August 2017: 2.3%

22



Wages and core inflation should rise

• The trillion-dollar question in economics at the moment is why falling unemployment has not led to an acceleration in wage growth. Nearly all measures suggest the labour market is tight, but some economists argue that a combination of globalisation, automation and the new “gig economy” are keeping wage growth depressed. While these factors probably are weighing on wage growth, we don’t believe that the historical relationship between a tight labour market and rising wage pressures is likely to have disappeared completely.

• In fact, several indicators suggest that wage growth should soon start to accelerate. The National Federation of Independent Businesses survey shows more firms are planning to raise wages. It also shows an increase in plans to hire new staff and a rising level of firms with job vacancies that they are struggling to fill. Workers are also positive about the labour market. The Conference Board Consumer Confidence survey shows a rising number of people think jobs are plentiful—unsurprising given that job openings are at the highest level since 2000. This is leading to an increase in the number of people quitting their jobs. Job moves tend to come with pay rises and as more people start to move jobs, companies come under increasing pressure to pay their existing staff more in order to hold onto them.

• Core inflation has fallen so far this year, dragged down almost entirely by a change to mobile data plans and base effects for medical services after a price surge in 2016. However, if wage growth starts to accelerate core inflation should start to rise again. The positive economic outlook signalled by the current high level of the ISM Manufacturing Business Survey is another signal that has historically tended to flag that core inflation should soon start to rise.

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US inflation and wages

ISM Manufacturing and core inflation

Wage growth and companies planning to raise wages

Index level, advanced 18 months (LHS); absolute change in year on year core CPI in % (RHS)

% change year on year (LHS); % of businesses (RHS)Wage growth and US quit rate% change year on year (LHS); % of total employment (RHS)

Source: (Top) ISM, Thomson Reuters Datastream, J.P. Morgan Asset Management. Light grey columns indicate recessions determined by NBER. (Bottom left) BLS, NFIB, Thomson Reuters Datastream, J.P. Morgan Asset Management. NFIB companies planning to raise wages is a 12-month moving average. Wage growth is average hourly earnings of total private production and non-supervisory employees. (Bottom right) BLS, Thomson Reuters Datastream, J.P. Morgan Asset Management. US quit rate is a three-month moving average. Wage growth is average hourly earnings of total private production and non-supervisory employees.Guide to the Markets - UK. Data as of 30 September 2017.

ISM Manufacturing

Core CPI

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'01 '03 '05 '07 '09 '11 '13 '15 '171.0

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Wage growth Wage growth

NFIB companies planning to raise wages

US quit rate

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Recession


MARKET INSIGHTS

More people quitting their jobs could lead to a rise in wages.



• Rising wages and inflation could cause US interest rates to rise faster than markets are expecting, with negative implications for US government bonds.

• The risk of a US recession in the next 2—4 years is rising. However, if wage growth and interest rates remain low or productivity picks up, then the cycle could potentially last longer.

• Despite rising medium-term risks, the key point is that low recession risk in the next 12—18 months still suggests a continued positive environment for US equities in the near term.

MARKET INSIGHTS

Wage growth and interest rates have normally had to rise to higher levels before the economy enters recession.

The economy should be able to withstand some increase in wages and interest rates

• If wages and core inflation do start to rise, the Fed may have to put interest rates up faster than the market is currently expecting. In the medium term, the risk is that rising wages start to put pressure on corporate profits and rising interest rates increase the cost of servicing both corporate and consumer debt. Eventually, companies might respond by cutting business investment and staff in an effort to preserve profitability. While this makes sense for an individual company, when many companies cut costs at the same time, it can trigger a recession. Consumers may also reduce spending in response to higher borrowing costs.

• The good news is that interest rates and wages will be rising from a very low starting point, so the economy can probably withstand at least one more year of interest rate rises and wage acceleration.

• Beyond the next 12 months, in the absence of an external shock, the timing of the next recession could well be determined by the pace at which wage pressures accelerate and interest rates rise.

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US wages and interest rates

US wage growth and Fed funds rate% Fed funds rate (LHS); % change year on year (RHS)

Source: Thomson Reuters Datastream, US Federal Reserve, J.P. Morgan Asset Management. Wage growth is average hourly earnings of total private production and non-supervisory employees. Light grey columns indicate recessions determined by NBER. Guide to the Markets - UK. Data as of 30 September 2017.

Wage growth

Fed funds rate

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Recession



The eurozone recovery is being driven mainly by growing domestic consumption.

3 European equities and the euro

Blowing tailwinds support the eurozone and the euro

• In the second quarter, eurozone GDP grew at 2.3% year on year—the fastest growth rate since 2011. The unemployment rate is falling fast to 9.1%, down from the peak of 12.1% in 2013. Economic and consumer confidence reached 10-year highs and leading indicators are raising expectations for next quarter’s growth.

• Faster growth is not yet translating into meaningfully higher core inflation, which remains below the ECB’s target of 2%. For this reason, the central bank is maintaining its very dovish tone, declaring that rates will remain unchanged “well past” the end of quantitative easing. Despite still-low inflation, a reduction in QE is likely to start in January 2018.

• The euro has strengthened on the back of stronger growth and expectations of tighter monetary policy, but this is unlikely to derail the recovery in the eurozone. Consumption contributes around 55% to eurozone GDP vs. 5% for net exports. The effects of the rebound in consumption on the recovery are more relevant than the risk of a stronger euro, which represents a manageable headwind. Euro exports still grew strongly before 2008 despite a much larger appreciation in the euro than we have recently witnessed.

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Eurozone: GDP and inflation

Contribution to eurozone real GDP growth Contribution to eurozone CPI inflation% contribution to GDP growth, change year on year % contribution to headline inflation, change year on year

Source: (Left) Eurostat, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Right) Eurostat, FactSet, J.P. Morgan Asset Management. *CPI is the Consumer Price Index. Core CPI is defined as CPI excluding food, alcohol, tobacco and energy. Guide to the Markets - UK. Data as of 30 September 2017.

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ECB inflation target

Change in inventories

Net exports

Investment

ConsumptionGDP

Government

Food, alcohol, tobaccoCore rate

EnergyCPI*

Average since 2000 Q217

1.3% 2.3%

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MARKET INSIGHTS

OVERVIEW

• Europe continues to show signs of a solid and broad-based recovery. The expansion is accelerating thanks to falling unemployment and rising consumption.

• The European Central Bank (ECB) is likely to start reducing its quantitative easing (QE) purchases next year, with interest rates only rising once QE has come to an end.

• A stronger euro doesn’t mean European companies can’t still deliver strong earnings growth.


MARKET INSIGHTS

The tide is turning for European equities

• Many investors are still cautious about investing in Europe. In 2016, political uncertainty driven by the rise of populist parties led to large outflows from European equities. This year, however, flows have returned to European equities. Election risks did not materialise and better earnings and economic momentum has led to some increase in investor confidence in the region.

• The outlook for European corporate earnings will be key for the future performance of European equities. The recovery in profit margins in Europe is lagging significantly behind the US. However, in the last nine months, European margins have started to improve. This is an indication that some of the margin gap is cyclical and European companies are profiting from the acceleration in global growth and the recovery in the eurozone.

• Recent euro strength versus the US dollar has raised some investor concerns. A stronger euro could prove a drag on earnings and revenues from abroad. However, investors should keep in mind that roughly 50% of revenues of European companies come from inside the EU, so strong domestic growth should boost these domestically driven earnings. Meanwhile, strong global growth should more than offset the drag on international earnings from a stronger euro. Pre-2008, despite a much stronger rally in the euro, European companies were still able to triple their earnings per share.

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European equities

European earnings vs. the euroLast 12 months’ earnings per share, euros (LHS); US dollars per euro (RHS)

Europe vs. US operating profits margins%, earnings per share / sales per share

European equities flowsEUR billions, cumulative

Source: (Left) MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Top right) MSCI, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) GFICC Quantitative Research Group, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 30 September 2017.

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MSCI Europe ex-UK

S&P 500MSCI Europe ex-UK EPS

EURUSD

-80

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0

20

Jan '16 Apr '16 Jul '16 Oct '16 Jan '17 Apr '17 Jul '17


Pre-2008, a strong euro did not prevent earnings from tripling.


• Strong domestic European growth, combined with a solid global growth backdrop, should continue to support the recovery in European equities.

• If the euro appreciates further, this could favour domestic focused companies over exporters.

• Nevertheless, exporters should still be able to grow their earnings even if the euro appreciates further as the boost from healthy global growth offsets the drag from the currency.


4 Japan: Improving corporate governance

The Japanese economy is doing well

• Japanese growth has been robust so far in 2017. Inflation levels remain low, but concerns over the economy falling back into deflation seem to be subsiding. Japanese earnings have also been detaching from a reliance on a weak yen, which is supportive of Japanese equities.

• The Tankan business survey, which asks thousands of Japanese companies about current business conditions, as well as their intended activities over the next year, is showing an improvement. Both manufacturing and non-manufacturing industries are heading upwards, suggesting a broad pick-up in the Japanese business environment.

• The labour market remains tight, with the unemployment rate continuing to trend downwards. The jobs-to-applicant ratio shows that there are over 150 jobs available for every 100 job seekers. Despite this tightness in the job market, wage growth remains low.

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Japan economic indicators

Bank lending and job-to-applicant ratio% lending growth year on year (LHS); ratio of number of jobs to applicants (RHS)

Real wage growth and labour market% change year on year, six-month moving average (LHS); % (RHS)

Tankan business conditionsIndex level

Source: (Top left) FactSet, J.P. Morgan Asset Management. (Bottom left and right) Thomson Reuters Datastream, J.P. Morgan Asset Management.Guide to the Markets - UK. Data as of 30 September 2017.

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Job-to-applicant ratio

Bank lending (y/y)

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OVERVIEW

• Japan’s economy looks to be in good shape, with strong GDP growth, low levels of unemployment and improving business sentiment.

• Corporate governance best practices have taken longer to be adopted by Japanese companies than other developed markets. This presents upside potential for stocks that can improve their delivery of positive shareholder returns.

• Japanese equity valuations are not expensive compared with history or other markets, and exhibit weaker correlations to other major equity markets. This means that investing in the asset class can help to diversify portfolios.

Bank lending is finally rising after years of deflationary credit contraction.

MARKET INSIGHTS


A sea change in corporate Japan

• A shift in corporate culture is underway in Japan. Corporate governance, and the focus on increasing returns to shareholders, has been improving. Historically, Japanese companies have held large amounts of cash on their balance sheets when compared to other global companies. Japanese corporates are increasingly using the money that they once held as cash to pay dividends and initiate share buybacks to the benefit of equity investors, as seen on the left-hand chart.

• The increased use of return-on-assets and return-on-equity targets is another sign of the growing focus on delivering shareholder returns. Japanese companies have notably lagged other major markets in this respect, often focusing more on building market share than on return on investment. However, the proportion of Japanese companies that are now including return-on-investment targets in their medium-term plans is growing.

• We have also seen the quality of company boards improve over the past few years. The number of businesses appointing external directors has doubled since 2010 and there has been a shift towards appointing multiple external directors to increase the independent influence on boards.

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Japanese equities: Corporate governance

Listed companies’ dividend pay-out and share buybacksYen trillions

Companies citing ROE & ROA targets in medium-term plans% of 841 companies

Appointment of outside directors at Japanese companiesTotal

Source: (Left) Nomura, J.P. Morgan Asset Management. *Share buyback data is for repurchases of common stock, excluding repurchases from Resolution and Collection Corp. and repurchases of preferred stock collected by Nomura. 2017 figures for share buybacks and dividends are estimates. (Top right) Goldman Sachs,Japan Investor Relations Association, J.P. Morgan Asset Management. ROE is return on equity and ROA is return on assets. (Bottom right) Goldman Sachs, Tokyo Stock Exchange, J.P. Morgan Asset Management. Companies are Tokyo Stock Exchange companies. Guide to the Markets - UK. Data as of 30 September 2017.

Equi

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DividendsShare buybacks*

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0

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2014 2016

ROEROA

One independent external directorAt least one external director, not independent

At least two external directors

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2010 2012 2014 2016



• Japanese equities could deliver positive returns over the medium term, driven by attractive valuations and an improving business environment, which is supported by healthy growth and continuing accommodative monetary policy.

• In the past, the performance of Japanese equities has been tied to the strength of the yen against the dollar. In recent times, Japanese earnings have been less dependent on a weak currency and investing in this asset class should no longer be viewed as just a currency play.

• In a market where many businesses and industries face structural challenges, there will be a wider divergence in the performance of companies going forward. Active managers have the ability to avoid stocks with less promising outlooks, as well as focus on a combination of “new” industries for which Japan has a sustainable advantage and corporates that aim to deliver higher shareholder returns.

MARKET INSIGHTS

Adoption of shareholder return targets has increased, but still has room to run.

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MARKET INSIGHTS

MARKET INSIGHTS Quarterly Perspectives - J.P. … Perspectives UK | Q4 2017 ... economic and...

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