The 2017 outlook for equities
A volatile path
The ride might be bumpy because some expectations are already high, political hurdles such as elections or rising protectionism lie ahead and geopolitical risks abound. We would however advise against counting on much better entry points as so many investors have missed the uptrend until now and so much money waits for investment opportunities.
High single-digit earnings growth to drive gains
Regression models point to 5-7% earnings growth if the global economy grows slightly faster than 3%. Earnings growth can be faster than the models imply because energy companies will be able to capitalise on much higher levels of the oil price than at the start of 2016, which will have a powerful impact on cash flows, and financial companies will benefit from rising yields and declining provisioning needs. Dividends and share buyback should be a second pillar supporting the positive total return of equity investments. Valuations on the other hand, with a background of rising Fed funds rates, are unlikely to add a positive contribution, or if so, only marginally.
US stocks are undeniably expensive, whether we look at PEs, the P/B, the cyclically-adjusted PE, the median PE… and even at the dividend, which stands below the 10-year Treasury yield, in a unique situation among major countries. We nevertheless see upside. It is based on earnings growth.
Earnings have the potential to climb by approximately 8% if not more depending on the size of tax cuts by the new administration. Such an outlook is based on the view that revenue growth of 5% is probable, a boost comes from the repatriation of foreign earnings, the energy sector contributes positively this year (from a very low base) and tax cuts are somewhat accretive to the bottom line.
Also taken into consideration are the negative impacts from a slight deterioration in margins and a strong dollar.
Earnings are at cyclically-depressed levels, after having undergone a long series of negative impacts, such as the sectoral problems in financials and in commodities (both “explain” 30% of the earnings underperformance versus the US since 2007), poor operating margin trends (22% explanatory power) or a much more timid wave of share buybacks.
The disappointment from sales growth is much smaller. Economic activity has been very resilient over the last few quarters in the euro area and leading indicators send a promising message. Thanks to their strong leverage to the global cycle and strong contributions from the commodity and financial sectors, euro-area companies should be able to deliver earnings growth close to 10% in 2017. The strength of the dollar will add a final layer to the good earnings outlook.
The combination of a favourable outlook for earnings with attractive valuations (CAPE, P/B, dividend yields and relative to bonds) should allow euro area stock markets to deliver above average returns. There is a heavy political agenda in 2017 but the fears about populist parties are very widely shared and thus “in the price”. The worst is far from certain so that we keep our positive stance on euro area stocks. Because Germany benefits from monetary conditions too accommodative for its own fundamentals, domestic demand trends are solid.
Given its high cyclicality, exposure to emerging countries, this is a market that should keep outperforming within the area. Its valuation is attractive (but it is true that it appears so thanks to the solid rise in earnings seen over the last few years).
The macro environment is improving markedly thanks to the 15% yen depreciation since late September and the favourable trend in the global economy. Exports are prime beneficiaries but investment spending should also be well oriented whilst consumption should be supported by slightly rising wages. A new economic package could come in the summer.
These trends are very supportive for cyclical stocks, of which Japan has the highest share in the index among the countries we follow. The JPY remains the key driver of stock prices. Its recent weakening and further weakness over coming months will support the outlook for earnings.
Given that the currency trend leads by three months the trend in earnings revisions, the recent improvement in the revisions index should continue at least until next March. Earnings growth will also be helped by continuous improvements in corporate governance, which allowed earnings to be more resilient recently than implied by the first half jump in the yen versus the dollar.
Share buybacks should stay strong and foreigners are likely to return to Japan given all the above dynamics. Given their low equity exposure, domestic investors should also feed the uptrend in coming months. Valuations remain attractive with a relative PE nearly at its lowest since 1990 and the price-to-book not reflecting the improvement in the ROE of companies.
With more than 70% of sales generated outside the UK, the outlook for the currency is a key determinant of earnings prospects.
A lot of uncertainty surrounds the potential currency paths, as the Brexit process will be long and tortuous. Our base assumption is of a slight appreciation as a lot of caution is already priced in.
The impact on earnings would thus be mildly negative. Among the non-domestic sectors, materials and energy have a solid earnings outlook, which is already well taken on board by investors in the case of the former.
The other non-domestic sectors either face uncertainties, such as financials with the question marks around the effect of the Brexit, or are defensive in nature, hence susceptible to neglect by investors. Looking at domestic sectors, they are vulnerable to the negative impact of rising inflation on consumer disposable income or to the Brexit uncertainties.
All these trends leave us with the prospect of below average earnings growth. Thanks to a 4% dividend yield and a moderate price-to-book ratio, UK stocks are well supported. The upshot is that UK stocks have only limited upside potential in 2017. We stay neutral.
Mid-January, two years will have passed since the abolition of the minimum exchange rate. The country slowly recovers from this shock. Leading indicators point a rosy picture.
A lot will depend on whether the Swiss franc will be forced to play its safe haven role or not. Our base scenario sees a benign environment with key rates unchanged for at least the next 12 months.
Earnings are expected to grow again, after two years of decline. For equity investors, the fact that the global economy is accelerating and that bond yields are rising means that the Swiss stock market is likely to underperform, due to its defensive composition.
In terms of valuations, strong support comes from the dividend yield, around 3.5%, but the price-to-book and the PE are around their long-term average. All in all, we stay neutral. On mid-caps however, we remain positive. They benefit from the global reflation trade, have strong earnings growth prospects, solid balance sheets and reasonable valuations.
Cyclical trends are moderately positive according to leading indicators. The growth differential versus developed countries is widening in favour of emerging countries. It must be highlighted that a lot of this improvement relates to countries (Brazil and Russia) leaving recession behind.
At the level of companies, there are also signs of improvement with a stabilisation of the return on equity. For the time being, it is mainly thanks to cuts in production capacities, which help improve asset turnover. Still, chances are good that a reversal in the ROE lie ahead, with unit labour costs well under control and the positive outlook for global growth.
There are however important risks in coming months. First of all, the recent weakening of the yuan creates deflationary pressures for other emerging countries. Secondly, the Fed will continue to raise rates and further rises in bond yields are expected, which support a strong dollar and create constraints on emerging central banks. Finally, the incoming new US administration creates a lot of uncertainties with regards to the outlook for trade and geopolitical risks have been rising in Asia.
This remains the region that we favour within emerging countries. We retain our neutral stance on the latter, because of the fundamentals mentioned here and because valuations are in line with long-term averages.
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Returning risk appetite
Over the last 10 years, net flows towards global equities have been negative. The absence of appetite to take risks related to the very anaemic character of economic activity which required the intensive care of central banks to stay afloat, in the face of budgetary austerity, lack of dynamism in final demand and paucity of reforms. Over summer, optimism began to grow, on signs of resiliency and rising expectations of budgetary support in a large number of countries. This has been best illustrated by the reversal of fortune for cyclicals, which began outperforming. We expect markets to keep rising thanks to moderate acceleration in global economic activity.