#Market Strategy — 06.10.2017

Equity markets: be pro-cyclical!

Roger Keller

The outlook for equity markets stays fundamentally promising (please refer to our previous message). Two markets have above average upside potential. Discover which ones!

US stocks have upside potential, but constrained by valuations: we are neutral

The US dollar is down nearly 10% on a trade-weighted basis since the start of year. This adds approximately 4 percentage points to earnings growth on the S&P500. Going forward, we expect the combination of faster sales growth, stable margins and a stronger dollar will lead to earnings growth of nearly 10%. Corporate tax cuts would boost significantly the 2018 EPS growth rate.

These good earnings prospects are however already well discounted. Valuations are undeniably high: the Shiller PE has been higher only in 1929 and in 2000 and the 12-month forward PE, the price-to-book or the price-to-sales are all above their long-term averages. Because of these high valuations, upside potential for US stocks is below average. As a result, although we expect new record highs to be reached, they will not be much higher than current levels. We are thus neutral US stocks.

More upside for the euro area, thanks to good EPS growth upside and attractive valuations: we are positive

The euro area stock market is sensitive to exchange rate movements. According to some calculations a 10% appreciation of the euro takes approximately 6 percentage points off euro area earnings per share growth. The euro has risen by 8% over the past 5 months, hence the diverging euro area stock market trend since May and its movement towards the 200-day moving average.

In coming months, we expect the euro to lose some of its strength, that economic data remain solidly oriented and that operating leverage helps deliver strong earnings growth. Share buybacks and M&A activity should be additional positives. If valuations are broadly in line with long-term averages, PE-based valuations are penalised by the cyclically-depressed level of earnings. Additionally, account should be taken of the low level of bond yields, which improves the relative valuation standing of equities. In terms of country selection, we currently have no market preference within the euro zone.

Japan is positioned to outperform: we stay positive

A general election is planned for October 22. Prime Minister Shinzo Abe is most likely to win it. The current economic expansion is the longest in a decade and benefits from strong domestic demand and exports. GDP should continue to grow above potential in 2018. Beyond a favourable macro backdrop, Japanese companies are able to show strong earnings growth and revisions thanks to their increased focus on improving ROE. Strong operating leverage is a big trump card given the current environment of accelerating global growth.

An expected weakening of the yen will be another contributor to above average market progression by Japan, given its benefit to exporters and the strongly negative correlation with the equity market trend. It is in addition the only one among the major stock markets that takes advantage from rising bond yields, which we expect over coming months. Finally, valuations also support a positive stance as they are attractive.

Due to poor fundamentals, we are neutral on the UK

Most valuation indicators - such as the cyclically-adjusted PE, the relative price-to-book or the dividend yield – place UK stocks under a favourable light. Unfortunately, they are at these below long-term average valuation levels for good reasons: the earnings outlook is poor. It is poor because of the deteriorating domestic economic climate related to the Brexit uncertainties.

It is also poor because of the sector breakdown of the UK stock market, which is much more defensive than the other major markets with consumer staples, healthcare, telecom services and utilities making up 36% of the FTSE100 index.

Above average valuations and defensiveness lead to neutrality on Switzerland

The Swiss franc has lost 7% since March, against the euro, and 5% on a trade-weighted basis. This is significant and very welcome for Swiss companies as they are generating sales and earnings mostly outside the country. Economic indicators are very strong with the PMI at a new cycle high of 61.2 and the KOF leading indicator compatible with solid growth.

Valuations already reflect in great part these positives as they are either in line with long-term averages or above them. Since the expected growth rate of earnings is below the world average due to the defensiveness of Swiss stocks, the upside of Swiss stocks is below average. We thus have a neutral stance.

Neutrality maintained on Emerging Markets

Emerging stock markets began reversing their multi-year underperformance from January 2016 and have recently broken important technical resistances. This has been made possible by rallying commodity prices, Brazil and Russia leaving recession behind, stimulus in China, continued Fed caution, declining bond yields, narrowing bond spreads, liquidity abundance, improvements in structural imbalances and, in 2017, a weakening of the US dollar. It is true that the rise has been narrowly based as just 1% of the stocks in the MSCI EM index have contributed 40% of the gains made by the index over the last 12 months. Seen from a sector perspective, technology has been the key performance driver.

In coming months, there is room for rate cuts in the emerging space, as real yields are still high. Apart from this helpful development, we find ourselves with a lack of positive drivers for a while: the number of coming Fed rate hikes is underestimated, bond yields and the US dollar are seen rising, bond spreads in developed countries have only a very limited potential to narrow further, if any, commodity prices should be without a clear direction and valuations are already fair.

The upshot is that we retain a neutral stance. Our preference for Asia stays intact, thanks to rising ROEs and higher exposure to the good macro trends in developed countries.