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#Market Strategy — 13.03.2017

Equity market outlook - March 2017 -

Roger Keller

Turning neutral over the short term (3 months) but staying positive over the medium term (9-12 months)

 

Equity markets have gained 16% over the last 12 months. On March 9, they celebrate 8 years of bullish trend. There are no reasons to fear an end to it. There are however reasons for higher levels of volatility, particularly over the next few months.

 

The medium-term bull market remains intact

The global economic and earnings outlook is good. Growth is poised to accelerate this year and next and will benefit from a wider set of contributors than just consumers: life is turning back into corporate capital expenditure, global trade improves and fiscal stimulus is contemplated in many places. Meanwhile, good job market trends and rising wages will fuel consumer confidence and sustain consumer spending, which will however be reined in somewhat by the negative impact on disposable income from higher energy costs. 

This environment supports acceleration in earnings growth from last year’s 2% growth, based on the MSCI All Countries World index. This is based on the expectation that sales growth should accelerate from 0% (again, for the MSCI All Countries World index) to 5% if not more (consensus view is 6%). Operational leverage will allow a higher growth rate for earnings. In addition, the energy sector will no more weigh on earnings prospects but could according to some calculations contribute around three percentage points to global market earnings growth. The same reasoning applies to financials but the contribution to total earnings growth should be much more limited due to structural headwinds. All in all, earnings growth around 10% seems achievable (consensus opinion is growth of 13%). 

Because valuations are already quite elevated, we do not count on the possibility in 2017 of seeing multiples expanding, which fits with the historical behaviour of equity markets in a context of rising official rates from the Fed. Thanks to dividends though – 2.5% on the MSCI All Countries World index - total returns around 10% sound realistic. Given that the MSCI All Countries World index is up by 5.5% at the time of writing, more than half of the price upside potential has already been achieved.

 

Turning neutral on the short-term outlook (3 months)

The world stock market has surpassed its May 2015 record high and thus established new historical highs. Over the last 12 months it has risen by 16%. We see both fundamental and technical reasons for turning neutral on equities over the next 3 months. 

On the fundamental side, first, economic surprises are in record positive territory, meaning that some mean reversion threatens, second, the diffusion index of leading indicators had reached high levels and began hesitating recently and, third, the rising gap between 10-year and 2-year Treasury bond yields means that volatility should rise over the next two years, which should not surprise at this advanced stage of the bull market. Given the good relationship between stock markets and the three factors just mentioned, which is explained by the anticipatory nature of both leading indicators and financial markets, turning neutral at this stage seems fully warranted, particularly in front of an upside potential that has become limited. 

On the technical side, markets are clearly overbought and complacent. Political risks have been brushed aside despite the fact that they are numerous: dense electoral cycle in Europe with high levels of animosity versus traditional parties, Brexit negotiations to begin in coming months, high levels of uncertainty over the US stimulus measures (timing and extent) and protectionist threats, to cite the most important ones. The most likely behaviour of markets over coming months is one of increased volatility, particularly ahead of political events. In case of a more significant down move, it would very likely prove to be very short-lived, thanks to the favourable economic background and accelerating earnings growth, which should feed animal spirits and a migration out of bonds into equities over the ensuing quarters.

To sum up, we turn neutral for the next three months as markets are already reflecting a lot of the fundamental positives that we expect and their overbought condition makes them vulnerable to political fears; the medium-term outlook remains sound and we keep our view that equities are the place to be in.

Equity markets have gained 16% over the last 12 months. On March 9, they celebrate 8 years of bullish trend. There are no reasons to fear an end to it. There are however reasons for higher levels of volatility, particularly over the next few months.