Investors should keep an eye on Japan, Europe, UK and emerging markets in 2018 having been “somewhat unloved” relative to US equities for some time, according to Schroders’ Duncan Lamont.
The Schroders head of research and analytics said investors have benefited from the longstanding equity market bull run in recent years led by North American stocks.
He said: “When we look back over the past three years, investors have earned remarkably similar returns in local currency terms in very different parts of the world.
“UK, eurozone, Japanese and emerging market equities have all returned close to 9.5 per cent a year. The US, as is well known, has been the outlier and star performer, delivering closer to 11.5 per cent a year.
“However, when we look behind the numbers at what has been driving that performance, we find an altogether different and more diverse set of circumstances,” he said.
As the below chart shows, returns between 2015-2017 were driven by completely different factors.
Composition of returns over 3yrs
Source: Schroders
The US market, said Lamont, has been driven predominantly by increasing valuations, with earnings growth contributing “next to nothing” to investor returns.
“The fact that US returns have been so poorly underpinned by fundamentals is a concern,” he said. “Stellar returns have been built on shaky foundations.
“This can only go so far but reassuringly, 2017 saw strong earnings growth in the US and 2018 is also shaping up for more of the same.”
Meanwhile, Lamont said the UK market has witnessed a “rollercoaster ride”, highlighting the impact of weaker commodity prices on listed companies.
“The decline in commodity prices contributed to a collapse in earnings over the past three years, given the market has a large allocation to this sector,” said Lamont.
“However, investors have been prepared to value companies higher relative to those depressed earnings, which has softened the blow.”
Elsewhere, in Japan and Europe returns have been fuelled by a combination of strong earnings growth and dividends, but the markets have failed to reflect better fundamentals in valuations “which have stagnated”.
As such, Lamont said this year investors should focus on the areas that have been “somewhat unloved” and not seen the same kind of growth experienced in the US. This includes Japan, Europe, UK and emerging markets.
“Despite generating the strongest earnings growth of all markets shown, the valuations of Japanese equities have languished relative to the rest of the world,” he said.
“They are lower at the end of 2017 than a decade earlier. After decades of poor growth, investors have remained somewhat untrusting of the recovery.
Performance of the TOPIX over 10yrs
Source: FE Analytics
“Should this hold out, then there is more potential here than just about anywhere else for increasing valuations to boost returns.”
Similarly, Lamont said valuations of stocks in Europe have not reflected improving fundamentals during the past five years and could leave some further room for outperformance.
“European equities have also not been hugely rewarded for the earnings recovery that has commenced,” he explained. “Valuations have hardly changed since 2013.
“Given their earlier stage of the economic cycle, earnings growth is likely to drive returns in 2018 with potential support from valuations.”
One of the most unloved markets over the past few years has been the UK, with ongoing Brexit negotiations continuing to fuel investor concerns.
“The UK equity market has been the worst place to be invested from an earnings standpoint,” said Lamont.
“Earnings rebounded sharply in 2017 but remain over 40 per cent lower than their 2007 peak and even 30 per cent lower than after their mini recovery which fizzled out in 2011.”
As one of the highest yielding global markets, an earnings recovery may be needed to ensure that payouts are sustained in the near future.
Source: Link UK Dividend Monitor
The head of research said: “A chunky dividend yield of close to 4 per cent provides a solid base for returns but unless earnings recover, this is unlikely to be sustainable.
“UK companies paid out 80 per cent of their earnings in 2017 to cover dividends, way above the long-term average of around 50 per cent.
“Commodity prices have rebounded and both dividends and earnings have a lot riding on that holding out.”
Lastly, Lamont highlighted emerging markets as an area for investors to watch this year. Despite their strong performance more recently, valuations have not risen as strongly as other markets, he said.
“The drivers of emerging market equity returns have been reasonably well balanced over the past three years,” said Lamont.
“Valuations have risen but are not as extended as in some other markets and earnings stand to benefit from the synchronised global recovery and weakness in the US dollar.
“The potential for positive contributions from all factors remains on the cards in 2018.”
He added: “At a very high level, the supportive economic backdrop suggests that earnings growth should positively contribute to all markets in 2018.
“The big differences could arise from valuations. No market is immune to falling valuations but that does not mean returns have to be negative, if the other two drivers contribute enough.
“A year of solid, if not spectacular, returns could be on the cards.”