#Market Strategy — 10.10.2016

Optimism in the stock markets despite short-term risks

Florent Brones

Over the past few months, the positive and negative factors have offset each other. Consequently, the markets are showing no clear trend: after each episode of strong pressure, e.g. the Brexit vote, a rebound takes place. Several risks remain...


Global economic growth remains a support

2017 should be the six consecutive year of global economic growth above 3%.  This remains a moderate growth level by historical standards, but this growth has been enough to improve corporate earnings. This trend should continue, on the one hand, thanks to the improvement in profitability in the energy sector (7% of the MSCI Wold AC index), which weighed last year due to the sharp decline in oil prices. On the other hand, the operating leverage effect will come into play. Companies have continually improved their cost base, and any rise in demand will translate into a rise in profits. This operating leverage is key in regions where corporate margins are presently small (Europe and Japan), in contrast with the US where margins are at record levels.

A change of policy mix?

This favourable environment for risky assets is partly due to the expansive monetary policies in place since 2008. The majority of these policies will continue to be pursued, particularly in Europe and Japan where Quantitative Easing programmes are in place.

In the US, however, the Fed is normalising its monetary policy through a rate hike last year, a rate hike this year (in December) and two in 2017. This is a very slight tightening of monetary policy.

Furthermore, as inflationary expectations remain below central banks’ targets, the question is: how effective are monetary policies? The financial markets are reacting less and less. Moreover, the ECB is starting to mention “tapering”, i.e. a gradual reduction of its bond purchasing programme, but it hasn’t given a time frame yet.

There is talk of a change in “policy mix” where fiscal policy plays a greater role, including in Germany where some people are asking for a large tax cut. Room for manoeuvre varies enormously between European countries. For example, in Spain it is limited due to the high fiscal deficit, but on the other hand, it is substantial in Germany.

Optimism in the stock markets despite short-term risks

A change in fiscal policy will depend a lot on the outcome of the upcoming elections. However, the financial markets perceive these political events as risks. It is true that the fiscal policy of the republican Trump will be different to that of the democrat Clinton. The real issue of the election (and possibility the worry) essentially concerns protectionism or isolationism, which is a central theme of the campaign.

In Europe, the next political event is the Italian referendum (4 December), followed by the French presidential elections (May 2017) and the general elections in Germany in autumn 2017.

Other events to watch are the UK budget which will be presented by the new Chancellor of the Exchequer on 23 November.  After the vote in favour of Brexit, but before the negotiation phase with the European Union starts (scheduled for 17 March), the British authorities might be the first to launch this new “Policy Mix” to offset the negative impact of difficult EU talks on the economy.

Short-term risks therefore remain, but the general environment is still favourable: economic growth, rising profits, ample liquidity, accommodating central banks.