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#Investments — 11.07.2017

Favour pro-cyclical stock markets for the second half

Roger Keller

In our previous comment, we described the outlook for the second half as being in two stages, a first one of consolidation before the uptrend resumes. The latter should be under the leadership of what are called high beta and pro-cyclical stock markets. This does not deny the potential for the US stock market to still reach new record high territory.

Neutral opinion on the US, due to high valuations

With high margins, an elevated ROE and forward earnings 34% above their 2007 record high, the US stock market finds itself in a mature phase of the bull market. In addition, its valuation is extended, however one looks at it (PE, P/B, P/sales…); relative to bonds, valuation appears less extended though. Nevertheless, US stocks still have room to reach new record heights, thanks to further earnings progression in 2018. Potentially, the earnings cycle could be extended thanks to tax cuts. Our expectation of four more rate hikes before the end of 2018 is no handicap to a continuation of the bull market; it merely means increased volatility should be counted upon.

Positive on the Euro area, with all cylinders firing

Domestic demand trends are solid, export demand is strong and the ECB will contemplate a first rate hike only from the second half of 2018. The region’s stock market being very sensitive to economic conditions, due to the high level of companies’ fixed costs, the current and prospective environments are very favourable to the trend in stock prices through the benefits of operating leverage.

After a false start in 2015, earnings are finally positioned to narrow significantly the gap versus their 2007 high, which lays 30% above the current prospective estimate. Earnings growth will also be boosted by favourable base effects for financial companies and for commodity-related companies. Share buybacks are another important positive force for earnings growth. The rosy outlook is comforted by reasonably attractive valuations, whether looking at absolute or relative valuations. Foreign investors are expected to come back in force given all these attributes and the much reduced levels of political risks.

Positive on Japan, on good economic momentum

Japan’s stock market is the one with the highest proportion of cyclicals. The economic momentum is good – not only exports but increasingly domestic consumption and capital expenditure - and inflationary pressures are slowly building as the economy works at full capacity.

These attractive attributes should allow Japanese stocks to deliver above average returns in coming quarters, as they imply good earnings growth trends. This prospect is reinforced by a good positive relationship between a rising stock market and rising global bond yields. Pressure on the yen as the interest rate differential favours the dollar will comfort the upside potential of the stock market. Finally, share buybacks and attractive valuations will also add their weight to the outperformance potential.

Neutral the UK, on rising uncertainties

On top of the Brexit uncertainties, the political situation has become more unstable after the recent results in the General Election. Meanwhile, the outlook for consumption has darkened, with real wage growth turning negative and consumer confidence deteriorating.

Corporate confidence reflects the uncertain economic outlook. The only bright spot is exports, which take advantage of the sharply weaker pound. Overall then, earnings prospects are poor for domestic-oriented sectors. We are nevertheless not underweight UK stocks. We are neutral because 70% of the FTSE100 revenues are generated outside the UK, allowing low double-digit EPS growth for 2017.

As soon as the currency benefits fade, earnings growth will revert into single-digit territory. In addition, their 2017 path is vulnerable to the vagaries of commodity prices as 23% of the FTSE100 index finds itself in the commodity space. Finally, valuations are aligned to their long-term averages. One attraction is the dividend yield. It offers 4%.

Neutral on Switzerland, on both mid and large caps

Last month, we downgraded our view on Swiss mid caps from positive to neutral because of a valuation premia that has gone up to the highest levels seen over the last 15 years. They remain a very attractive investment for the medium to long term, particularly if the Swiss franc loses some ground.

On the large caps, we are neutral as earnings growth is likely to be only single digit, valuations are around their long-term averages and the defensive nature of the SMI should prove a headwind when later in the year new positive momentum on global equities emerges thanks to the good dispositions of the global economy.

In our previous comment, we described the outlook for the second half as being in two stages, a first one of consolidation before the uptrend resumes. The latter should be under the leadership of what are called high beta and pro-cyclical stock markets. This does not deny the potential for the US stock market to still reach new record high territory.