#Market Strategy — 11.09.2017

Which stock markets have the best upside potential?

Roger Keller

Limited upside for the US: we are neutral

The US stock market has been able to reach new record highs despite receding hopes for significant growth boosting measures by the Trump administration. The 8% decline in the value of the US dollar on a trade-weighted basis allowed reaching these new record highs. A 10 percentage point decline in the value of the dollar adds approximately 4 percentage points to earnings growth. Looking ahead, we expect the US dollar to regain part of the lost ground and that margins begin to feel pressure from rising wages. Fortunately, better sales growth should mitigate the impact of wages on margins. There are thus high odds for high single-digit earnings growth in 2018 and for still further new record high stock prices. We retain however a neutral stance on US stocks because of valuations. They already discount a rosy scenario. Only compared to bonds are valuations not rich, but it is because bond valuations are even richer.

Earnings catch-up potential and attractive valuations lead to a positive opinion on Euro area stock markets

Mid-May, the area’s stock market was back to its 2015 record high. This good performance has since then been substantially eroded by an 8% rise in the euro on trade-weighted terms. A 10% appreciation of the euro takes approximately 6 percentage points off euro area earnings per share growth; earnings revisions are also closely correlated with the euro. Expectation of a period of euro weakness, signs of solid economic trends, both on the domestic and on the export fronts, high operating leverage and lastingly accommodative monetary conditions are ideal circumstances for outperformance of euro area stocks. Share buybacks and M&A activity are additional positive factors and valuations are supportive. Significant inflows from foreign investors should also be expected now that the political background has improved significantly.

Attractive valuations and solid fundamentals speak in favour of an outperformance potential for Japan

The recent newsflow indicates that domestic demand is now the key driver and that trade remains promising. It becomes more and more obvious that deflation is finally being left behind. Japan being the most pro-cyclical market, these trends are strongly supportive of solid earnings growth and of the view that Japan is well positioned to outperform. Meanwhile, trends in interest rate differentials should drive the value of the yen lower, which is historically a positive for Japanese stocks. Another important positive correlation is between rising bond yields, which we expect, and a rising Japanese stock market. Finally, valuations are attractive and back the potential for further outperformance.

Neutral on the UK, on poor fundamentals

Underperformance is set to continue. Domestic trends are unfavourable: consumer confidence has deteriorated and real wage growth has turned negative whilst corporate confidence is the victim of the Brexit uncertainties. Overall then, earnings prospects are poor for domestic-oriented sectors. Because 70% of the FTSE100 revenues are generated outside the UK, these domestic trends are less important than activities in the rest of the world. There are good reasons for optimism here, particularly as the British pound is cheap. We nevertheless remain neutral because of the sector breakdown of the index, which is more defensive than for other countries, resulting in more moderate earnings growth potential in coming quarters but also in a higher than average dividend yield (4.2% versus 2.4%). Valuations are in line with their long-term averages.

Neutral on Switzerland, because of its defensiveness

The economic outlook is good with the PMI at a new cycle high and the KOF leading indicator compatible with solid growth. But like the UK, more important is the outlook for the global economy and the fact that the Swiss stock market is more defensive in nature. On the positive side, the recent weakening of the franc will benefit sales and earnings; on the negative side, operating leverage is limited with 59% of the market in defensive sectors, which limits the upside for earnings growth and leaves the latter below the global average. With absolute valuations above long-term averages – except the dividend yield which offers an attractive yield of 3% - and the ROE slightly below, we remain neutral.

Neutrality maintained on Emerging Markets

Most indicators (liquidity tightening, rising interest rates, deteriorating narrow and broad money trends, outlook for property and other investments to slow down…) point to some growth deceleration in China. New orders in Latin America and Emerging Asia are deteriorating. Emerging market exports growth is slowing down. These trends require caution in the short term. For the medium term, we remain convinced that China’s slowdown will prove limited and that the growth gap between emerging markets and developed markets will widen again in favour of the former. This is historically a key driver of the relative performance of emerging markets. But for now, market complacency on the number of Fed rate hikes, expectations that bond yields and the US dollar (EM underperform 72% of the time when the dollar strengthens) will be rising, and an outlook for stable commodity prices are all factors that lead us to stay neutral with a medium-term preference for Asia. In our previous comment, we described the outlook for the second half as being in two stages, a first one of consolidation before the uptrend resumes. The latter should be under the leadership of what are called high beta and pro-cyclical stock markets. This does not deny the potential for the US stock market to still reach new record high territory.

Bottom line

Given that we expect a Goldilocks economic environment for the foreseeable future, we believe that the euro area and Japan, the most pro-cyclical markets, have the best upside potential.