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#Investments — 07.06.2016

Our views on global equities : an update

Roger Keller

In a nutshell, we retain a moderately constructive stance for the medium term

In coming months, stock markets should struggle in finding catalysts for resuming a clearly-defined uptrend, because of rich valuations, of a lack of earnings dynamism and of macro data remaining inconclusive. In the end, stock markets should nevertheless be able to gather strength but the upside potential will be closely related to the pace of earnings progression, which we see as being single digit. We continue to have a preference for developed markets.

Volatility to prevail over coming months

Although a certain number of fears have receded - such as recession in the US, hard landing in China, negative impacts of a low oil price and of a strong dollar on global earnings prospects – several risks still lie ahead (Brexit, disappointing macro numbers, Fed rate hike pace…). On the one hand, they form the proverbial wall of worry that markets need, to have the possibility to climb. On the other hand, markets already reflect positive expectations about earnings growth, with earnings-based valuations around their highs of the past decade and a price-to-book ratio slightly above its 10-year average. As a result, the combination of expensive markets with low single-digit earnings growth and a probably hesitant stream of macro news will result in a period of stock market volatility, before fundamentals – in the form of improving earnings momentum and confirmation of continued economic expansion - allow the resumption of a moderate uptrend later in the year.

Macro is key

Equity markets absolutely need to see continued economic growth to be able to reach higher levels. Their liquidity-driven phase is now clearly behind. Investors have given authorities, mainly central banks, the benefit of doubt that they can reflate the world economy. If the latter does not remain on its growth tracks, then downside risks would be very sizeable, not the least because of the issue of deleveraging. Fortunately, we see enough reasons for anaemic growth to continue to prevail.

Earnings in a bottoming phase

Our main scenario thus remains that earnings growth will progressively improve over coming quarters, with a good chance that current expectations of 2-3% growth for 2016 prove too cautious as investors take into account the oil price recovery. For 2017, earnings are expected to grow at a rate slightly faster than sales, thanks to better margins in non-US countries. We however do not share the consensus view that there is potential for double-digit earnings expansion, because we are in a world of anaemic growth and the positive impulse of cost containment is bound to slowly disappear. A corollary of this, is that the total return of equity investments will continue to see a significant contribution from dividends.

 

Going nowhere… fast

Our assumption that equities will lack positive catalysts over coming months and that they will follow a volatile path does not mean that we see substantial downside risk during this phase. Of course, we cannot exclude this as we will enter a period of lighter trading volumes and sentiment can bring prices temporarily to extremes but there are several reasons to believe that downside risks are limited. In other words, markets are likely to go nowhere …fast!

The first reason is the inflection in global earnings revisions and momentum that are clearly discernible; it can in great part be attributed to the steep recovery in the oil price, which is up 30% since the beginning of the year.

A second reason is sentiment, which stands at relatively depressed levels, a positive element from a contrarian perspective.

A third reason is investor positioning: the rotation out of equity funds and into bond funds is strongest since early 2009 according to JP Morgan and the same reading can be made out of the Bank of America Merrill Lynch fund manager survey.

Interestingly, hedge fund redemptions in Q1 have been the worst since 2009. A fourth reason is the strong support coming from dividends, which have rarely been as attractive compared to bonds in several decades. Finally, the vigilance of authorities and their focus on reflation could also be considered as an element limiting downside risks.

 

Preference for developed stock markets kept

The rapid recovery of emerging markets since their January 21 low has proved being nothing else than an oversold rebound.

Its main drivers have been a reversal in the oil price starting on the same date and a weakening in the US currency, which provides breathing space for many emerging countries.

Lately, the greenback has regained strength on the back of rising probabilities of rate hikes by the Federal Reserve over coming months.

At the same time, question marks about whether China benefits only from a positive mini cycle have surfaced with weaker data. Hence our preference for developed markets.

 

The euro zone: poised to deliver above-average returns 

In the short term, the Brexit risk will represent a key brake to any potentially positive development. Political risks will remain present durably (Spanish elections, Italian referendum,…).

Fundamentals speak however for favourable medium-term trends. First of all, the region’s economy should prove very resilient and a progressively improving outlook for emerging countries in 2017 will add to the attractions of EU stock markets, as they are leveraged to the global cycle. Earnings are still at cyclically-depressed levels, so that the above average valuation readings on the PE or the P-to-EBITDA should not be given too much weight; a preference should be given to valuation tools such as the price-to-book, dividends or comparisons to bond valuations.

The latter is all the more attractive as monetary policy will stay ultra-accommodative for a considerable period of time still. A progressive move of the EUR/USD parity to 1.08 should also contribute to the positive outlook.  

Japan: positive outlook based on attractive valuations and expectations of Abenomics 2.0 

Corporate earnings have recently suffered a significant hit from the sharp appreciation in the USDJPY from an average of 120 over 2015 to the 110 region recently.

Diverging policies between the Fed and the BoJ should drive the parity progressively back to the 115 region. This should improve earnings prospects, which will also benefit from a 3 percentage points boost in 2016 coming from a lower corporate tax rate, from reductions in special charges (restructuring and asset impairment), from continued share buybacks and from a slight improvement in exports.

Meanwhile, the Abe administration is expected to make several announcements over coming months to help reinvigorate Japan’s economy: after a frontloading of fiscal spending, the sales tax increase planned for 2017 has good chances of being postponed, a supplementary budget should be announced soon and structural reforms will continue. Finally, with a forward PE slightly above 13 times, valuations are attractive.

 

Neutral on US stocks: upside constrained 

Even if the UK decides to stay in the European Union, the outlook remains subpar: 70 of sales are generated outside of the UK and would thus be penalised by a further recovery in the pound, particularly as 30% of those revenues come from the emerging space, where prospects stay very uncertain.

With regards to the country’s economic outlook, it is characterised by decelerating growth rates due mainly to lower levels of consumption: an intensifying fiscal squeeze is hurting household disposable income and the outlook for jobs is deteriorating because of the poor trends in the oil industry, for capital expenditure and for exports.

In case of a vote for Brexit on June 23, then UK stocks would be hurt heavily because of the strong negative impact on domestic activity (consumer discretionary and utilities) and on the financial sector. At a prospective PE of 16 times, the UK market is at its most expensive level in 10 years. This is also at a premium to the rest of the world, which is a very rare phenomenon.

 

Neutral on US stocks: upside constrained 

Even if the UK decides to stay in the European Union, the outlook remains subpar: 70 of sales are generated outside of the UK and would thus be penalised by a further recovery in the pound, particularly as 30% of those revenues come from the emerging space, where prospects stay very uncertain.

With regards to the country’s economic outlook, it is characterised by decelerating growth rates due mainly to lower levels of consumption: an intensifying fiscal squeeze is hurting household disposable income and the outlook for jobs is deteriorating because of the poor trends in the oil industry, for capital expenditure and for exports.

In case of a vote for Brexit on June 23, then UK stocks would be hurt heavily because of the strong negative impact on domestic activity (consumer discretionary and utilities) and on the financial sector. At a prospective PE of 16 times, the UK market is at its most expensive level in 10 years. This is also at a premium to the rest of the world, which is a very rare phenomenon.

 

Neutral on the UK, due to a negative trend in earnings

Even if the UK decides to stay in the European Union, the outlook remains subpar: 70 of sales are generated outside of the UK and would thus be penalised by a further recovery in the pound, particularly as 30% of those revenues come from the emerging space, where prospects stay very uncertain.

With regards to the country’s economic outlook, it is characterised by decelerating growth rates due mainly to lower levels of consumption: an intensifying fiscal squeeze is hurting household disposable income and the outlook for jobs is deteriorating because of the poor trends in the oil industry, for capital expenditure and for exports.

In case of a vote for Brexit on June 23, then UK stocks would be hurt heavily because of the strong negative impact on domestic activity (consumer discretionary and utilities) and on the financial sector. At a prospective PE of 16 times, the UK market is at its most expensive level in 10 years. This is also at a premium to the rest of the world, which is a very rare phenomenon.

 

Emerging markets: staying neutral, uncertainties abound 

As soon as the US currency began strengthening again (in early May), emerging markets began losing a third of the gains they made since their late January low. Their outlook remains less promising than for their developed counterparts.

The first reason is the uncertain macro outlook, well reflected in economic surprises, in China’s PMIs which straddle the 50 expansion/contraction line and in rating downgrades on EM debt whose ratings are at their lowest in 6 years, as are the number of issuers at risk of downgrades by Standard & Poor’s.

A second reason is that further impulses from commodity prices are now most likely to become much scarcer. The nearing of the next Fed rate hike is a third reason, as it reduces policy flexibility for many EM countries.

A fourth reason is that consensus earnings expectations in high single-digit territory still seem too high for us given the lack of positives for ROEs. Finally, valuations are either in line with the 10-year average when looking at the 12-month forward PE of 12 times or reasonably attractive when looking at the price-to-book, which went back down to 1.3 times.

 

Read our detailed analysis on our Voice of Wealth app available from the App Store and Google Play