Applied philosophy: Are global equities in a typical mid-cycle phase?
After a period of uncertainty in Q3 2024, global equity markets settled down in the autumn. The US Presidential election had an impact, although we expect that to fade. In our view, how the equity market cycle progresses is more likely to be driven by economic fundamentals and valuations. We think that global equities are in a mid-cycle phase and use previous episodes to determine how it may develop.
We would have been surprised if the Presidential election in the United States had no impact on global equity markets. We may not view politics as being the most influential factor in driving equity returns, but we cannot deny the importance of this event. Investors also tend to pay a lot of attention to it, reflected in the number of questions we received around the election.
Global equities have responded to the election of Donald Trump with some enthusiasm possibly on the prospect of tax cuts and deregulation and their impact on economic growth, although they retreated from the highs reached a few days after the results were announced. Positive equity returns are not unusual in post-election periods, although every cycle is different (see here for more detail). This probably means that the equity market cycle that started in October 2022 is likely to continue and stay in the mid-cycle phase, in our view. Clarity would certainly be welcome after the uncertainty in Q3 2024. Determining where we are in the market cycle is also the first step in our model sector allocation process.
If the more positive sentiment around economic growth turns out to be justified, it would be good news for earnings growth. On the other hand, we must keep a watchful eye on the discount factor, mainly driven by future expectations for inflation and interest rates, in our view.
We think the way these economic fundamentals shape up, alongside valuations are the main factors that will determine how the equity market cycle develops. Thus, we have examined the characteristics of the environment during each mid-cycle upswing phase in the past. We followed the methodology outlined in this report, using 12-month trailing real GDP growth in local currency and consumer price inflation (CPI) in the nine markets that have been consistently among the largest by market capitalisation since 1973 in the Datastream World Total Market index (United States, Japan, United Kingdom, Eurozone, Canada, China including A+H-shares, Australia, Switzerland and South Korea). What is the template this period tended to follow?
As Figure 1 shows, global GDP growth tended to be relatively stable in three out of five mid-cycle upswing phases, especially in the last two (2004-06 and 2011-20). The average growth in these periods was 2.2% (excluding the most recent one that started in October 2023), with the weakest average growth during 1992-98 and 2011-20 at 1.8%, while the strongest growth was recorded during 1984-87 phase at 2.9%. This suggests that current levels of global growth at just under 2% could be sufficient to underpin a continuation of the equity cycle.
Notes: Data as of 22 November 2024. We show a proxy measure for global GDP growth using trailing 12-month real GDP figures in local currency for the United States, Japan, the United Kingdom, the Eurozone, Canada, China, Australia, Switzerland and South Korea. We calculate a weighted average annual GDP growth using their market capitalisations based on Datastream Total Market indices in US dollar. Showing quarterly data since 1st January 1975. The last data point shown is Q3 2024. GDP data included in the GDP growth series from 1975 for US, UK, Canada, Australia, South Korea, from 1981 for Japan and Switzerland, from 1993 for China and 1996 for the Euro Area. Shaded areas denote the mid-cycle phase in the equity market cycle (see Figure 8 for dates of market cycles).
Source: LSEG Datastream and Invesco Global Market Strategy Office
Current trends in our measure of market capitalisation-weighted global inflation also seem similar to what tended to happen during the same phase in past equity market cycles. In four out of the five mid-cycle upswing phases in our sample, the year-on-year inflation rate fell in the first 12 months, except in the 2004-06 cycle, when it gradually rose throughout. Also, for example in the 1990s and the 2010s inflation stabilised close to the 2% level that most developed world central banks target. As with GDP growth, it seems to us that current inflation rates are unlikely to prevent equity markets to “grind higher”.
However, our main concern when it comes to the equity market is not the rate of growth, or inflation. We view the global economy as having returned to “normal” after pandemic-related dislocations that took perhaps longer to settle than we expected at the time. Starting valuations at 16.2x, based on price/earnings ratios, were not the highest at the beginning of the mid-cycle upswing phase that started in October 2023 (they were higher at the beginning of both the 1992-98 and the 2004-06 period at 19.1x and 17.9x, respectively) but were nonetheless elevated. Although multiple expansion is common even during this more mature phase of the equity market cycle, there seems to be less scope for it when staring valuations are high (Figure 2).
Notes: Data as of 22 November 2024. Past performance is no guarantee of future results. Based on the Datastream Total Market World Index using daily data from 1 January 1973. Source: LSEG Datastream and Invesco Global Market Strategy Office
We expect these valuations to restrict returns, especially in regions that look significantly overvalued versus their respective historical norms. That includes the US, which accounts for 62% of global stocks (based on market capitalisation using the Datastream Total Market World Index as of 31 October 2024). While we expect central bank target rates to continue falling towards “neutral”, we do not think they will provide a significant boost, especially if bond yields, our proxy for the discount rate, remain near current levels.
Therefore, we think that global equity returns will increasingly rely on earnings growth as the main driver of returns. Our base case implies that economic growth will reaccelerate in 2025 boosting the prospect of higher earnings growth, albeit with a lag. Falling inflation could also help to keep costs manageable, thereby limiting the risk of margin erosion. In our view, the biggest risk is that growth undershoots, which would push both earnings growth and perhaps even valuations lower potentially ending the current equity market cycle. However, with supportive monetary and fiscal policy (most importantly in the US) we view this as a tail risk. We also think a significant rise in inflation in the next 12 months is a low probability event, although higher tariffs are likely to increase that risk in the medium term.
In our view, our base case implies that equity markets will “grind higher” staying in the mid-cycle phase. Nevertheless, keeping in mind where valuations are, the prospect of any economic upturn may already be partly priced in. Although we remained Underweight in our model asset allocation (Figure 6), we prefer financials as the sectors most likely to outperform in this environment (Figure 7).
