Higher volatility expected but equities remain an asset class of choice

Macro trends dictate the outlook for stock markets

2017 should be the sixth consecutive year of global economic growth slightly above 3%. This is clearly a subdued pace but is sufficient to allow an improving earnings momentum. Part of this improvement will come from disappearing headwinds: from the energy sector (still nearly 7% of the MSCI World AC index) and from the strength in the US dollar (US stocks make up 53% of the index and emerging countries another 11%).

In fact, the energy sector should boost the outlook for 2017 earnings thanks to basis effects and self-help. Another part of the improvement comes from operational leverage. A second rise in the Fed funds rate, expected in December, should not be seen as a handicap but more as a sign that the background remains supportive; this could, beyond short-term volatility, feed risk appetite, particularly as other central banks will either keep their policies ultra-accommodative or increase their support. At the same time, expansionary fiscal policies should also raise risk appetite.

Our earnings expectations are much lower than consensus

The consensus view is that earnings could be expanding at a growth rate of 13% in 2017. This seems to us too optimistic. We would expect a growth rate in the 5% to 7% region.

First of all, US companies will at best be able to maintain margins stable; this would align earnings growth to the rate of growth in sales, to which we can add the contribution of share buybacks. Elsewhere, operational leverage and share buybacks should allow earnings growth rates above sales growth rates.

Upside potential aligned with earnings prospects

Reflationary efforts over the last few years have resulted in a big part of the money remaining in the financial system instead of going into the real economy. As a result, bond yields have reached new historical lows and equity markets have gone through a phase of revaluation.

Valuations today can be described as being on the expensive side but they are not at extremes, at least outside of the US. Valuations are usually a poor tool for anticipating returns over a 12-month horizon but over a 10-year period, they are excellent “forecasters” of returns.

Their message over such a horizon is that returns will be moderate on average. With regards to the next 12 months, we believe that the main catalyst for global equities will be the trend in earnings, i.e. we expect mid-single-digit stock price gains. Given that stock markets over the last few years have risen despite poor investor participation, we cannot exclude that in the end, some capitulation by sceptics will not push markets higher than the mid-single-digit progress that we expect.

We are however inclined to believe that this will happen in a later stage, when investors will come to the conclusion that TINA has arrived. TINA stands for “There Is No Alternative”. We are not there yet.

Higher volatility in the short term should not come as a surprise

We see three groups of reasons for higher volatility in coming weeks: political, economic and policy related. On the political side, the US election and the Italian referendum stand out as the major hurdles.

On the economic front, it is not only the release of leading indicators such as the PMIs but also the beginning of the earnings season soon that could create waves in stock markets. On the policy front, we essentially have in mind the December rate hike by the Federal Reserve, which could impact negatively emerging stock markets.

Downside risks should in the end prove limited as sentiment is already on the cautious side, positioning is prudent, and the fundamental trend remains positive. Clearly, if we were to witness deterioration in the global economic growth outlook, a hard landing in China or political disruptions, then our core scenario would suffer. We struggle in finding upward risk scenarios.

Not yet time to like emerging markets as much as their developed counterparts

The growth differential between emerging and developed countries is expected to reach a low in 2016. It should go in favour of the former from 2017, as some countries keep accelerating (India, Indonesia, Mexico), thanks to past reforms, others leave recession behind and benefit from basis effects (Brazil, Russia) and as China’s growth rate stabilises above 6%.

Because of overbought conditions, an expected rise in volatility in coming weeks and ahead of the next Fed rate hike, we believe that we can wait before upgrading emerging stock markets to the same positive stance as developed stock markets.