Global equities broke out last week, ending the two month consolidation phase. A strong earnings season, upbeat guidance and reduced geopolitical uncertainty have spearheaded the breakout and financial conditions have eased substantially falling to multi-year lows.
Last September we postulated that the global Equity Risk Premium (ERP) would continue to narrow on the back of easy global monetary policy and a recovering global economy. While the Fed has hiked interest rates twice since then, global monetary conditions remain loose and we doubt they are about to abruptly tighten. Leading indicators signal that the global economy is also on track to continue expanding at a healthy clip, sustaining a goldilocks equity market scenario.
Historically, the ERP and global growth have been inversely correlated. The current message is to expect a further narrowing of the global ERP. Importantly, the ERP has consistently moved higher, rising about 300bps per decade on average for the past 20 years. Were the ERP to break 4% (and still remain ~200bps above last decade’s mean) from 4.84% currently, all other things equal, then the MSCI All-Country World Index (ACWI) would rise by 15%.
Nevertheless, regional equity market returns will not be uniform. Drilling beneath the surface of recent G3 performance is instructive. As a reminder last September we highlighted that “the laggards (Eurozone and Japan) will have to do the heavy lifting in order to propel the MSCI ACWI into uncharted territory”.
Indeed the Eurozone and Japan have been leading the charge especially since the Trump election. While the U.S. has hit a small speed bump recently, the Eurozone and Japan are firing on all cylinders according to sharply divergent Economic Surprise Indexes (see Chart). The implication is that Europe and Japan are well positioned to sustain their equity leadership position in the coming months.
True, the bond market has not yet confirmed the equity market’s euphoria, but leading indicators…