#Market Strategy — 15.01.2018

The 2018 stock market outlook

Roger Keller

Our preference for pro-cyclical markets remains intact

In a nutshell, we believe that US stocks still retain an attractive upside potential in 2018. It is however likely to be higher in the euro area and Japanese stock markets. Switzerland is likely to compete also closely with the US.



Thanks to tax cuts - which should add 7 percentage points to 2018 earnings - and the repatriation of earnings – which will certainly lead to a resurgence of lively share buyback (and M&A) activity - profits growth in the US in 2018 remains largely above sales growth. Adding the contribution from a slightly weaker dollar and marginal pressure on margins from higher wages in the analysis, we come up with a 12% EPS growth in 2018. Earnings growth in the US thus remains very attractive in international comparison.

Tax cut-related earnings upgrades do not change the valuation conclusion. Clearly, the stock market has already discounted a substantial part of the benefits of lower taxes by raising the forward PE ratio by 0.5 points of PE over the last two months, rendering expensiveness even more extreme. Other ratios such as the price-to-book or the price-to-sales lead to the same conclusion.

The upside for US stocks is clearly constrained by these high valuations. We have therefore a preference for other more pro-cyclical markets. Another reason for favouring other markets is our expectation of 3 rate hikes by the Federal Reserve versus none by the ECB or the BoJ.


The 8% rise in 2017 in the euro on a trade-weighted basis is the key explanation why euro area stocks have not been able to outperform. From current levels, the currency should no more make significant progress.

Attractive fundamentals should thus be able to assert themselves. We see three key drivers for outperformance in 2018. The first is the outlook for earnings growth. Since the middle of 2016, the earnings catch-up story has begun to materialise. Domestic demand and export trends are solid whilst operating and financial leverage is strong and share buyback activity will give an additional boost to the bottom line.

The second driver should be a steepening of the yield curve with short-term interest rates seen remaining stable well past the end of 2018 whilst bond yields follow the global trend upwards. These trends will benefit financials, which make up 21% of the Euro Stoxx index. Finally, valuations are only around their long-term averages, providing room for revaluation as investors get convinced by evidence and liquidity stays abundant.


Fundamentals remain very well supported. Private investment is strong and should remain so given the high level of corporate confidence, the dearth of people looking for a job and the preparations to the Tokyo 2020 Olympic Games. Exports should stay well oriented, despite moderating activity in China. Consumer spending should stay well oriented thanks to a strong job market, rising wages and despite some strengthening of inflationary pressures. Such a background will contribute to a continuation of solid earnings growth. Meanwhile, the focus on defending the interests of shareholders will remain unremitting. It is one of the explanations for the fact that earnings have kept growing over the last few quarters despite lateral fluctuations in the yen. The other explanation is the strength of domestic demand. Japan retains the capacity to keep outperforming thanks to good earnings growth prospects, room for a rising dividend payout ratio - which is the lowest among major countries -, strong share buyback potential, an expected moderate decline in the yen and attractive valuations, which should lead to fund inflows into Japanese stocks, among others from foreigners, who are still underexposed.


The Brexit uncertainties weigh on the economic outlook, both on the consumption and investment spending fronts. As a result the earnings outlook is poor. The defensive structure of the UK stock market is also part of the explanation why the earnings growth outlook is subpar. It is likely to be mid-single digit. Because of its below average beta, the UK stock market will remain neglected by investors. On the positive side, valuations already reflect the high level of uncertainties but they are likely to remain under pressure as the Brexit path will be long and tortuous.


Switzerland has among the brightest prospects for earnings growth, with approximately 15% for 2018. This is partly to be attributed to the 6% weakening of the franc on a trade-weighted basis since the middle of 2017. It is however mostly related to the impact of a healthy world economic environment, from which Swiss companies heavily depend. Many companies have revenues generated outside the country that make up at least 90% of total revenues. With such bright earnings prospects, Swiss stocks would appear in our list of stock market favourites were it not for their high valuations: 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 world equity market, in the upper part of the range seen in the last quarter century. The upshot is that the upside for Swiss stocks is likely to be not as good as the one we expect from the EU and Japan but they are well placed to perform at least as well as US stocks. The dividend yield of more than 3% is attractive.


The main attraction is the economic outlook and its impact on earnings growth and the return on equity. Emerging countries will grow at least twice as fast as developed countries for the foreseeable future. This provides a strong foundation for earnings growth. ROEs have improved in the IT, materials and energy sectors. Going forward, ROE improvements should extend also to staples and industrials. Valuations are another attraction of emerging stock markets, all the more so if one takes into consideration the substantial rise of the share 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, this slowdown should prove limited but until it does so, investors are likely to be nervous. We keep our preference for Asia ex-Japan, China and India in particular.

In a nutshell, we believe that US stocks still retain an attractive upside potential in 2018. It is however likely to be higher in the euro area and Japanese stock markets. Switzerland is likely to compete also closely with the US.