This week’s IDB considers revisits equities, considering current valuations, future earnings expectations and the implications for London & Capital portfolios.
High valuations can be supported by growth and high expectations require growth, but this dependence could result in a toxic combination if such growth does not appear.
Earnings expectations have remained firm, with sector level earnings recovering in 2017 led by cyclically driven industries. However, the forecast for earning growth in 2018 comes from a very different mix of sectors, with technology and construction being predicted leaders of growth. Forward earnings estimates are demanding but not unimaginably so, however forecast error remains a risk.
With earnings expectations always generally too optimistic, valuations have become increasingly important. Although Cyclically Adjusted Price/Earnings Ratios (PEs) are a better indicator of longer term equity returns than shorter term, developed market valuations are now full and unlikely to increase much further from here. The consequence, is a dependence on continued earnings growth to fulfil predictions.
Economic growth will be essential at sustaining equity valuations, leadings indicators currently point towards firm economic conditions and momentum. In the US wage growth is showing tentative signs of improvement, which is essential given the integral nature of the consumer in the US economy.
Elevated corporate earnings expectations and valuations mean wariness is starting to increase in equity markets, so a practical approach to portfolio management is needed.
At London & Capital we have started the process of tapering risk to reflect higher future risks and lower expected returns. Our stock selection for CORE STAR equities focuses around ‘Goldilocks earning growth’ (not too high or too low) with defendable valuations. Growing Government, REIT STAR and EuroDom still have a role to play at selectively tapping into equity themes. Emerging Markets require selectivity but relative attractions are still strong.