#Investments — 02.05.2017

Equity Markets: Our Medium-Term Preferences

Roger Keller

The world economy is expected to grow by 3.4% in 2017 and 3.8% in 2018 and to experience some strengthening in inflationary pressures. This context is promising for markets called pro-cyclical, such as the euro area and Japan.

They are likely to outperform the US, which is very expensive, and the UK and Swiss large caps, the latter two being defensive in nature. Emerging markets face some constraints that limit their upside potential.

Positive view on the euro area: stars are well aligned

This time is different! These are usually dangerous words, ones that we do not like to hear and even more to pronounce. But it is true; domestic activity has been a key engine of growth! In previous cycles, exports had usually been the main driver of the recovery. Now, the euro area is firing on all cylinders.

As a result, earnings have rosy prospects, between positive operational leverage, share buybacks and positive base effects for financials and commodity-related companies. Political risks seem to be fading, for this year at least. These favourable trends are accompanied by valuations that are attractive (CAPE, P/B, dividend yield and relative to bonds). The upshot is that the euro area has above average upside potential.

Positive on Japan, due to its pro-cyclical profile

Japanese stocks are usually prime beneficiaries of accelerating global growth - thanks to the high share of cyclicals in the index - and rising US bond yields. They have however been disappointing year-to-date, because of the strength of the yen, poor domestic economic news flow and lately a retreat in the global reflation trade. We nevertheless believe that Japanese stocks are positioned to deliver above average returns, because the economic outlook remains positive and we expect the yen to weaken markedly.

Recently, economic surprises have resumed improving. Meanwhile, the large fiscal stimulus enacted late in 2016 will start bearing fruit soon, the strong improvement in real M1 heralds better GDP numbers in coming months and inflation is slowly returning. These trends plus continued share buyback activity should feed solid earnings growth, whose revisions have until recently been frankly up. On valuation grounds, Japan is attractive. Its relative PE is nearly at its lowest since 1990 and the price-to-book is not reflecting the ROE improvements.

Neutral on the US: high valuations are a major issue

The Shiller PE is nearing 30. It has been more expensive than currently only twice, looking back until 1871: in 1929, just before the Great Depression, and in 2000, at the time of the technology bubble.

The median PE stands at 24, a level that was in the past followed by extremely poor returns (and an average drawdown of 18% within the following three years). Other valuation tools send the same message that US stocks are no more a buy-and-hold asset. For the time being however, we remain firm holders thanks to the positive momentum in the US economy and in earnings. There is still room for the S&P500 reaching new record highs, all the more so if tax reforms allow raising earnings estimates for 2018.

Neutral on the UK

Thanks to the double-digit decline in the value of the pound since the Brexit vote, earnings growth should be strong in 2017 (70% of revenues are generated outside the UK). This follows 5 years of declines and precedes a year when earnings progression will return to be below average, not the least because of the defensive nature of the UK stock market.

This year’s solid earnings growth outlook represents thus an exception, which is greatly attributable to the commodity-related sectors that make up 23% of the FTSE100 index. Consensus bullishness on earnings is susceptible to downgrades if, as we expect, the British pound strengthens. Given that valuations are in line with their long-term averages and the uncertainties around the Brexit negotiations, we remain neutral.

Switzerland: neutral on large caps but positive on mid caps

The return to health of the Swiss economy proceeds better than most specialists had expected. With 60% of exports going towards the European Union, which is undergoing a period of above potential growth, earnings prospects for Swiss companies are good.

After two years of contraction, they are poised to see earnings growing again at a double-digit pace in the case of small and mid caps, which we like as they are well positioned to capitalise on the positive trend in the global economy. Large caps are however unlikely to see earnings growing at a double-digit pace, due to their defensive characteristics and despite their global presence. Their valuations are in line with long-term averages, looking at PEs and at the price-to-book ratio. As a result, we stay neutral on large caps.

Neutrality maintained on Emerging Markets

Emerging stock markets have capitalised on a more favourable trend in PMIs since the beginning of the year than in developed countries, a weaker dollar, declining bond yields, a reversal up in earnings revisions (in positive territory for the first time since February 2011) and a lack of news on US trade restrictions.

From now on, lack of momentum in commodity prices, expected rises in the Fed funds rate, rising bond yields, a strengthening dollar militate for lacklustre returns. In addition, the technical picture is supportive of neutrality between overbought conditions and negative divergences.

Another reason behind our stance is the presence in China of early indications (credit impulse, monetary conditions) that the economy will slow down, which will impact countries that export to China significantly. We have taken note of the reversal in China’s PPI, which has negative implications for industrial profits. Finally, uncertainties remain clearly present about what protectionist policies the US could be contemplating. With valuations in line with their long-term averages, we prefer to stay in such circumstances neutral, with an unchanged preference for Asia.