#Market Strategy — 06.11.2017

Equity markets: a preference for the pro-cyclical markets

Roger Keller

We believe that world equities are entering a late phase in the bull market. This is one that is still usually rewarding. It is also one in which investors finally express higher levels of conviction in their decisions and in which the markets with higher betas outperform. We confirm our preferences for the euro area and for Japan.

Valuations constrain the upside for US stocks: we remain neutral

US stocks have surfed on an 8% decline in the US dollar on a trade-weighted basis, since the beginning of the year. This tailwind is unlikely to be present in coming months. The backdrop is one of continued earnings expansion as sales accelerate and margins stay high.

The contribution from share buybacks should diminish given the deterioration of balance sheet health over the last few years. Earnings expansion could on the other hand be enhanced by tax cuts. The issue is that current valuations already incorporate high expectations. Beyond the Shiller PE, which has been higher only in 1929 and in 2000, other valuation measures clearly represent a hurdle for stock price rises. For example, the 12-month forward PE and the price-to-book ratio have been higher mainly during the technology bubble period.

All in all, US stocks still have the capacity to reach new record highs but the upside from current levels is below average in international comparisons. We thus stay neutral.

Above average potential for the euro area: we stay positive

Earnings stand more than 20% below their 2007 record high, because of the double-dip recession and slow pace of economic reforms. Since the middle of 2016, the situation is finally improving. Thanks to operating leverage, earnings are likely to grow faster than sales.

There is ample room for improvement in margins and for releveraging. After 12% earnings growth in 2017, 9% earnings growth is likely in 2018. Share buybacks should contribute in achieving these growth rates. If valuation ratios in absolute terms are around their long-term averages, they have nevertheless some room for progression as we get into later stages of the bull market.

This small revaluation potential will be helped by the expensiveness of bonds and the lastingly low level of interest rates as the ECB moves cautiously towards less accommodation. A 3% dividend yield is likely to attract fund inflows into equities from investors looking for yield. The upshot is that we are positive on the euro area thanks to an earnings catch-up story and room for revaluation.

Japan: we stay positive

The re-election of Shinzo Abe has been the catalyst for a 5% progression in the Topix during the month of October. This index is now 10% above its 200-day moving average. It is clearly in overbought territory. We nevertheless remain positive over the medium term as fundamentals remain very supportive.

First of all, the current economic expansion is the longest in a decade and economic confidence is strong. Nominal GDP is finally leaving a quarter of a century of lateral trend on the upside. Moreover, the Bank of Japan will keep its expansive monetary policy intact, which will weigh on the yen and benefit companies. Second, foreign investors remain underexposed with an allocation of less than 7% to Japanese stocks against an 8% share of the latter in the MSCI World All Countries index.

Third, profits are well oriented even though they have received no help from the yen this year. They benefit from margins that have reached record highs, which should not preclude them rising further as they remain below the world average. Finally, valuations remain attractive with low relative PE and price-to-book ratios.

Neutral on the UK

Earnings growth potential is below average. Brexit uncertainties weigh on companies, which reduce their spending plans, and higher inflation eats into consumer disposable income.

Another reason for more subdued earnings growth than elsewhere relates to the more defensive character of the UK stock market, which is a negative when global growth is well oriented as is currently the case. Because valuations are already below their long-term averages, they offer some support and justify a neutral stance.

Switzerland: upside potential in line with the MSCI World AC index. We stay neutral

This 7th largest stock market in the world trades at comparatively elevated levels. Its PE relative to the rest of the world is the highest since 1990 at least and its price-to-book relative stands at a 20% premium to the MSCI World AC index, which is in the upper part of the last quarter century range. In other words, a lot of positives are “in the price”. It is true that the economic outlook is promising, with GDP growth expected to accelerate from 0.9% in 2017 to 1.6% next year.

The weakening of the franc helps: it has lost 10% against the euro since March and the euro area is the main trading partner. On a trade-weighted basis, the Swiss franc has lost 6% over the same period. As a result, earnings growth prospects for SMI companies are good. They are in line with the expected growth rate for the rest of the world. We expect Swiss stocks to grow in line with the MSCI World AC index over the next 12 months. We are thus neutral.

Emerging markets: upside in line with the world index. We stay neutral

Emerging stock markets ended their relative underperformance going back to 2010 last July. This has been helped by rallying commodity prices, Brazil and Russia exiting recession, China continuing to grow strongly, Fed caution, declining bond yields, narrowing bond spreads, improving structural imbalances and a weaker dollar. Noteworthy is that 1% of quoted companies delivered 40% of the gains made by the MSCI EM index.

They are technology companies. In coming months, support will come from favourable economic growth, which will feed earnings growth in line with the rest of the world, and room for rate cuts in several countries. Headwinds will come from an expected strengthening of the dollar and from rising bond yields. As a result, the upside for emerging stock markets is similar to that of the MSCI World AC index. We thus stay neutral. Our preference for Asia stays intact, thanks to rising ROEs and higher exposure to the good macro trends in developed countries.