#Market Strategy — 06.12.2017

Equity markets: our regional preferences updated

Roger Keller

As the bull market reaches an advanced stage, do we maintain our pro-cyclical preferences? Discover why we retain our preferences for the euro area and for Japan and why Switzerland has an upside that is nearly as good.

US stocks have further upside potential. It is however limited by valuations. We remain neutral

US stocks are clearly very expensive in absolute terms, whether we look at price-to-earnings, price-to-book or price-to-sales ratios. Relative to bonds, the picture is less worrying, but it is true that bonds are very expensive. There is nevertheless further upside for US stocks thanks to continued earnings growth, particularly if tax cuts are finally being agreed upon. The latter could add up to seven percentage points to the S&P500 earnings. There will however no more be a contribution from expanding margins, which hover around historical highs. Nor will there be as significant a contribution from share buybacks, because of the deterioration of corporate balance sheets. Fed rate hikes will be a headwind. As a partial offset, a weaker dollar will provide benefits to the bottom line.

Euro area stocks have above average upside potential. We stay positive

The earnings catch-up story has taken time to materialise. Since the middle of 2016 it has finally begun. There is strong operating leverage. There is also room for financial leverage. Share buybacks will give an additional boost to the bottom line. In addition, moderately rising bond yields will benefit financials, which make up 21% of the Euro Stoxx index. Finally, the absence of any intention by the ECB to raise rates before 2019 means that liquidity conditions will stay very favourable. Absolute valuations are also supportive, being around their long-term averages. The main negative comes from the currency side, if the euro strengthens too much. Potentially, this could lead to a 3 percentage points decline in earnings estimates. This negative impact must be taken with a pinch of salt because in the past it has been more than outweighed by the positive impact on earnings of a solid economic expansion. And we expect growth to remain above potential, mainly thanks to the dynamism of domestic demand.

Japan retains potential to outperform: we stay positive

Fundamentals remain very supportive. First of all, growth is expected to stay above potential with corporate and consumer confidence at very strong levels and a monetary policy outlook for accommodation enduring. This will feed a continuation of solid earnings growth, which is backed by the increased focus within companies on defending the interests of shareholders. This focus has allowed earnings to grow in 2017, despite the lateral trend in the yen. Continued earnings expansion, room for a rising payout ratio, strong share buyback potential, an expected moderate decline in the yen and attractive valuations should lead to fund inflows into Japanese stocks, among others from foreigners, who are still underexposed.

Neutral on the UK, where the earnings growth potential is below average

The Brexit uncertainties cloud the economic outlook, both on the consumption and investment spending fronts. As a result the earnings outlook is poor. Valuations already reflect the high level of uncertainties and are likely to remain under pressure as the Brexit path will be long and tortuous. Another reason for staying neutral on UK stocks is that this is a market with a moderate beta, due to the defensive structure of the market.

Switzerland: upside potential nearly as good as for the EU and Japan. We stay neutral

Switzerland has among the brightest prospects for earnings growth. This is in part attributable to the 5% weakening of the franc on a trade-weighted basis seen over the last few months. The key reason however is that Switzerland’s companies are heavily dependent on the health of the global economy, which is solid. Were it not for their expensive valuations, Swiss stocks would feature among the favourite markets. But their PE relative to the rest of the world is the highest since 1990 at least and their 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. Hence, they are unlikely to deliver returns as good as EU and Japanese stocks but they are well placed to perform at least as well as the US.

Emerging markets: good fundamentals but near-term headwinds lead to a neutral stance

Emerging countries will grow at least twice as fast as developed countries for the foreseeable future, which should allow earnings growth in the former to be at least as good as in the latter, particularly as margin and ROE trends are good. The outlook is for ROE improvements beyond IT, materials and energy, to include staples and industrials. Valuations are reasonable, all the more so if one takes into consideration the substantial rise of the technology sector in the index. There are however three hurdles in the short term: an expected rise in the dollar and in bond yields, as well as the question mark about the amplitude of the slowdown of activity in China. In the end, it should prove limited and we keep our preference for Asia ex-Japan – China and India in particular - within emerging stock markets.