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#Investments — 05.02.2018

Outlook for equity markets: the February update

Roger Keller

In a nutshell, we maintain a bullish stance for the medium term but expect the path to new highs to be volatile.

We are fully in line with the consensus. So what are we missing?

We believe that the Goldilocks environment should prevail, that central banks will shift their policies gradually, that earnings growth will stay solid, that valuations can stay elevated, that the best stock market opportunities lie in the pro-cyclical stock markets. There is nothing original here. These are views that are extremely widely shared. Precisely because they are so widely shared, we are concerned that we may miss something. As the saying goes, “what is obvious is obviously wrong”… We are trying hard to see what we might be missing but we nevertheless find no reason to change our stance. Our checklist of issues to follow closely leaves us with the conclusion that we should stay with the consensus.

Why we remain fundamentally bullish

The factors that lie at the core of our positive medium-term stance are the synchronous character of the current period of expansion and the favourable global trend in capital expenditure, which leads to a virtuous economic cycle. These trends feed the expectation that earnings growth of 10% on a worldwide basis is a reasonable forecast, thanks to operational leverage (and the contribution of tax cuts in the US). The icing on the cake is the contribution of share buybacks to the bottom line. Because central banks are in the process of shifting their policies to less accommodative stances, our core scenario is that global equities rise in 2018 at a pace close to that followed by earnings. This means that stock markets have already achieved a substantial part of the expected upside. There is still enough progression to be expected to remain positive. One should also not dismiss the possibility that sentiment leads markets beyond our expectations as we are in a late stage of the bull market.

Why we expect volatility to rise

We have been expecting markets to go through a phase of consolidation for a large part of 2017, with a preferred path being a move down to the 200-day moving average (most of the time 7% lower than spot prices). Hence, we continuously retained a short-term neutral stance within a medium-term positive opinion. Since the creation of the Standard & Poor’s in 1927, there has never been a period such as the current one when the market rose for so long – 400 days and counting -without the occurrence at some point of a decline of at least 5%. Because markets are heavily overbought, bullishness has reached high levels, central bank policies are shifting and leading indicators are peaking, we retain our short-term neutral stance. 2018 should see the return of volatility.

Where are the key risks?

With valuations reaching high to very high levels, a focus on where negative surprises are the most likely to come from is required. Our main concern is a rise in bond yields that is faster than we expect, either because of inflation surprises, faster tightening by central banks or investor requirements for a higher risk premia. The concern coming next is if China growth were to decelerate faster than we envisage. The third concern is if global economic indicators were to cool more significantly and faster than we expect. Finally, we pay attention to the risks of protectionism and to geopolitics.  

Although equity markets are in a late stage of the bull market and find themselves in heavily overbought territory, we retain a positive stance. The path is likely to be volatile but worth being followed given the good visibility on the economic background.