#Market Strategy — 19.09.2016

Retaining a preference for developed stock markets

Roger Keller


Still a preference for developed stock markets.

The trend in economic surprises is more favourable in developed countries than in emerging countries and, though there are signs of improvement in the relative growth outlook of emerging stock markets, they remain too tentative for the time being.

As we get closer to 2017, this growth differential should nevertheless and finally turn in favour of emerging countries in our view. We should thus have in coming months the opportunity to become more positive on emerging stock markets as a whole instead of only on a selection of them.

The euro zone and Japan are our two stock market favourites within developed stock markets

Based on our view that the global economy will keep expanding and that fiscal stimulus will be decided upon in a certain number of countries, investor risk appetite should be nurtured. Higher beta stock markets are likely to be prime beneficiaries, also because the US has become expensive.

Our choice goes towards the euro area stock market and on Japanese stocks.

The euro zone: improving outlook for earnings, finally

Euro-area stock markets have suffered from the incapacity of earnings to make progress over the last five years. They have been weighed down by the impact of the steep decline in commodity prices on energy and materials companies, by strong structural headwinds for financials, by the continued deceleration in emerging country activity, by the lack of pricing power and by limited share buybacks.

The earnings outlook is improving: the basis of comparison for energy and materials companies will improve and self-help will impact their bottom lines positively; a gentle rise in bond yields should alleviate pressure on financials (which trade at similar valuation lows as during the global financial crisis and during the Sovereign Debt Crisis); stabilization and progressive improvement in activity in emerging countries will benefit EU stock markets as they are very sensitive to the global economic cycle; some help will come from a slight weakening that is expected in the euro.

Not to be forgotten is that euro-area stocks are characterized by high operational leverage: a slight improvement in sales has a very significant impact on the bottom line, due to high levels of fixed costs. Valuations are supportive looking at the price-to-book, at dividends and considering that earnings are at cyclically depressed levels.

Given the historically wide yield gap between equities and bonds, EU stock markets have the potential to generate an upside price movement bigger than the rate of growth in earnings. In other words, there is room for revaluation. Over a five-year horizon, there is room for EU stock markets to deliver superior returns based on expanding margins, on above average earnings growth potential (catch up potential) and on rising valuations.

Japan: positive stance maintained whilst waiting for Abenomics 2.0

This year’s 16% appreciation in the yen will weigh on earnings prospects until at least 2017, based on our currency forecasts.

Earnings are nevertheless still poised to grow thanks to reductions in special charges, cuts in the corporate tax rate, the significance of share buyback activity and an improvement in exports.

Valuations are attractive with a prospective PE around 13 times and a price-to-book ratio of 1.1 times. What is needed to unlock the upside potential is a new wave of policy measures. New measures are expected to be announced in coming months, combining monetary, fiscal and structural reform initiatives.

Neutral on US stocks, whose valuations are elevated

Drags from the slump in the oil price and from the strengthening in the US dollar are slowly fading. Earnings growth should accelerate as 2017 comes closer, thanks to positive sales trends and relatively stable margins. The contribution of share buybacks will decrease as companies will be more limited in using their balance sheets to finance them.

UK: neutral, better opportunities elsewhere

The Bank of England and the government have reacted fast to limit the downside impacts to the UK economy from the Brexit vote.

Still, consumer and corporate confidence have plunged and the postponement in invoking Article 50 to possibly the end of 2017 is only buying time for exporters.

Given the high level of uncertainties, UK stocks offer no attractive upside with valuations clearly high looking at a PE that stands at a premium to the rest of the world, which is a rather rare event.

Emerging markets: staying neutral and on the lookout for improvements in fundamental 

Since their January lows, emerging stock markets have substantially outperformed, on a combination of rising commodity prices, some improvements in economic conditions, such as things not getting worse in Brazil and Russia, and expectations that the Federal Reserve will move cautiously with its plans to raise rates.

Going forward, the oil price is expected to remain in a range, signs of economic stabilisation could spread as leading indicators improve whilst the Federal Reserve is positioning itself to raise rates in coming months.

These are not conditions that would justify continued outperformance. In the meantime, trailing earnings in local currencies are not yet stabilising and credit impulses are deteriorating. Valuations reflect fairly well these fundamentals. We stay neutral and on the lookout for signs of improvements in fundamentals.

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