Brazil and Russia Boost Global Equities While Germany and China Lag

Investors in global equities, after initially being severely rattled by the unexpected Brexit vote in the U.K. on June 23, have recovered their nerve since, and are now showing a small positive return year-to-date. The MSCI World Index is up 1.9% year-to-date in capital value, in the currencies of its component markets, and by 2.7% in U.S. dollar terms.

In the U.S., the S&P 500 has made a series of all-time highs, and at the time of writing had just closed at another one at 2173, for a year-to-date capital gain of 6.3%. The U.K. has staged a strong post-Brexit vote recovery, with the FTSE 100 Index up 7.8% year-to-date. European shares, however, have been markedly less resilient: The FTSE Eurofirst300 Index is down 6.4%, with both German – DAX index down 5.6% – and French – CAC index down 5.5% – equities contributing.

The Japanese market has risen strongly in recent weeks, possibly reflecting the strong re-election win of incumbent Prime Minister Shinzo Abe as well as the global reduction in investor anxiety, but is still well adrift of where it started the year, with the Nikkei showing a year-to-date loss of 12.4%. Non-Japanese investors, however, have seen the loss counterbalanced by the strength of the yen, which has appreciated by 12.5% against the U.S. dollar.

Emerging markets have done well, with a year-to-date capital gain of 9.6% in U.S. dollar terms. Again, the regional performance has been very diverse, and investors needed to have been invested in two markets in particular to have done well. In Brazil, the benchmark Bovespa Index is up 30.5%, and shares in Russia have also soared; FTSE Russia index is up 27.1%. In both countries the equity market gains have been amplified by exchange rate gains, with the Brazilian real up 21.5% against the U.S. dollar and the Russian rouble up 12.7%.

The other members of the key BRIC quartet, India and China, lagged behind. India’s Sensex Index gained a relatively modest 6.9%, while China’s Shanghai Composite Index is still 14.4% below its opening year level.

What is the Outlook for Global Equities?

Global economic activity continued to progress, though more obviously in the U.S. than in other developed economies, monetary policy was likely to continue to provide ample liquidity and to encourage investors to look favourably at equities on relative valuation grounds. There were, however, a range of downside risks, and although modest rates of economic growth remained the most likely scenario, investors should be prepared for further episodes of anxiety-driven volatility.

The relatively lopsided distribution of growth in the developed world continues, where the U.S. has been making all the running. On top of a better-than-expected jobs report for June, more recent data on retail sales and industrial production have also beaten expectations.

This solid performance by the U.S. economy is not necessarily translating into immediate strong corporate profitability. U.S. data company FactSet, which tracks both companies’ actual profit results and analysts’ expectations for future profits, estimates that profits during the June quarter at the S&P 500 companies were 5.5% lower than a year earlier, 2% lower ex the energy sector, where the U.S. “fracking” industry has been hard hit by the lower world oil price.

But more positively profits are expected to resume year-over-year growth in the current quarter, and to pick up further in 2017.

The latest July Bank of America Merrill Lynch global survey of fund managers, showed high degrees of risk aversion, low expectations for global growth and global profitability, and strong regional and sectoral preferences. The risk aversion could be seen from the proportion of cash held in portfolios: While still low in absolute terms, at 5.8%, the level of cash holdings was at its highest since late 2001. Greater anxiety could also be seen in the use of instruments to hedge equity risk.

Although most fund managers have still not resorted to taking out hedging protection against equity declines, the proportion taking out protection has reached a new high, a continuing a steady trend that started as far back as 2013.

When asked which markets they would be most overweight or underweight over the next year, unsurprisingly, the post-Brexit U.K. market is again deeply out of favour, though managers are even more concerned about Italy. Although the survey did not indicate the reasons, most likely the highly downbeat assessment represents a combination of higher political risk and severe problems within Italy’s banking sector.

By sector, managers are strongly of the view that a higher-risk outlook bodes ill for bank shares, and although they are still slightly underweight commodities, the degree of underweight allocation has dropped substantially in recent months as oil and other commodity prices have improved.

While investors are currently keen on emerging markets, the latest events in Turkey have shown that severe setbacks can occur virtually out of the blue; Turkey’s bonds, equities, and currency all took large and immediate hits. The most likely outlook is that world equities can continue jaggedly upwards, absorbing reverses on geopolitical or other shocks along the way, but there is a higher degree of uncertainty than usual around that central scenario.