Global equities enjoyed a strong start in 2017, driven by optimism about economic growth in the US and Europe. But political risk and valuation concerns undermined confidence toward quarter-end, highlighting a key dilemma facing investors this year.

Investor sentiment is being pulled in two directions. Will macroeconomic growth pull stocks up this year—or will political risk pull them down? This question was evident in the US, as stocks plateaued in late March after the government failed to pass a bill to repeal Obamacare. The move resulted from tensions within the Republican Party and dampened some enthusiasm about President Trump’s plans for tax cuts and fiscal stimulus, which had energized the market since the US election.

We believe that there are good reasons to stick with equities for the long term. And in the current environment, it’s especially important for investors to balance domestic and non-domestic exposures, as valuations and growth profiles differ from region to region.

Emerging-Market and Growth Stocks Rebound

During the first quarter, the MSCI World Index advanced by 5.4% in local-currency terms (Display, left). US large-cap stocks did well, though the rally in US small-caps that had been prompted by the election in November stalled. Emerging markets recovered from a setback late last year, as Chinese equities powered ahead. Japanese equities underperformed.

Global Equities

Global Equities

Most sectors did well. Cyclical stocks led global market gains (Display, right). Shares of resources companies underperformed as oil prices slipped modestly following their recovery in 2016. Growth and higher-quality stocks were back in favor during the quarter after underperforming last year. Value stocks disappointed.

Political Risk vs. Macroeconomic Improvements

Geopolitical risk is palpable around the world. Europe is coping with multiple flashpoints, from Brexit to the French elections this month to Italy’s huge debt burden and banking system crisis. In Asia, China is challenging several Asian nations over territorial rights in the South China Sea. Potential new trade barriers from the US are creating concerns for countries from Taiwan to Mexico. And conflicts in the Middle East continue unabated, with terrorist attacks spilling over to the West.

At the same time, global macroeconomic fundamentals are encouraging. In the US, robust consumer and business surveys, as well as strong job markets, have supported solid GDP growth since even before the elections. In Europe, manufacturing indicators point to a developing recovery, while the headline inflation rate of 2% in February met the European Central Bank’s target for the first time in four years.

Headline inflation has also been rising in Japan, and domestic data are pointing to modest growth. There are mixed signals coming from China, where investment has stagnated but producer prices have jumped, possibly signaling stronger growth.

Against this backdrop, earnings growth is picking up globally after a slowdown of nearly two years. On average, global earnings have grown by 6% a year over the last 30 years. If earnings growth rises into the high-single-digit range, driven by broad-based reflation and an acceleration of GDP growth, we believe that equity markets could deliver a positive surprise for investors.

What About Interest Rates?

Much will depend on what happens with inflation. In a reflationary environment, central banks, most likely led by the Fed, may move to raise interest rates from historically low levels. Rising rates are typically good for stocks, especially when they’re driven by a strengthening economy, according to our research. While we do not expect rapidly rising inflation, if it does rise too sharply, the broad benefits to stocks could be muted. Yet even in an inflationary environment, some stocks would do better than others in industries such as consumer-centric services and commodities.

Valuations in the Spotlight

With so many wild cards affecting market sentiment, valuations are in the spotlight. US, European and emerging-market stocks are relatively expensive when compared with each market’s 20-year history (Display, left), though they aren’t stretched to extreme levels. But valuations vary widely among sectors, industries, companies and countries; as the earnings outlook improves (Display, right), selective investors can still find attractive opportunities around the world, in our view.

Global Equities

In addition, our forecasts suggest that equity returns look attractive relative to expectations from bonds, in our view. Our median return projection for global equities is 6.2% annualized over the next five years, compared with about 1.3% for global bonds.* In a lower-return environment, we believe that stocks are an integral component for investors to meet their long-term goals.

Selective Focus for Uncertain Times

The investing environment is shifting. Equity correlations are declining, which means that individual stocks are trading more independently, based on their fundamental strengths and weaknesses. And the dispersion of equity returns has also started to rise from extreme lows. Lower correlations and higher return dispersion typically signal a better environment for active managers.

The tug-of-war for investor sentiment is likely to continue throughout the year. In equity markets, uncertainty often creates opportunity. So what should investors do? Make sure your equity allocations are balanced globally to capture diverse valuation and earnings benefits in different parts of the world. And focus on strategies that target businesses with long-term staying power or recovery potential that aren’t as likely to be derailed by political or macroeconomic developments.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein.


*Data do not represent past performance and are not a promise of actual results or range of future results. Projections are the median of 10,000 simulations based on the compounded annualized growth rate for the next five years. Bonds are represented by 60% global investment-grade bonds and 40% global sovereign bonds; stocks are represented by a universe similar to MSCI World; both are reported in, and hedged into, US dollars. Based on the AB Proprietary Capital Markets Engine, which is a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and rate of inflation, producing a probability distribution of outcomes; however, it goes beyond randomization by taking the prevailing market conditions into consideration and basing the forecasting on the building blocks of asset returns, such as inflation, yield spreads, stock earnings and price multiples. The analysis incorporates the linkages that exist among the returns of the various asset classes and factors in a reasonable degree of randomness and unpredictability. There is no guarantee that the returns presented will actually be realized.

Article by Sharon Fay, Alliance Bernstein