#Investments — 15.12.2016

Stock market outlook: riding the reflation trade

Roger Keller

Riding the reflation trade.

Since 2011, a reluctant bull has dominated stock markets. This is best illustrated by the outperformance of defensives over cyclicals since then, as a result of continuous disappointments on global growth, which then led central banks to increasingly creative approaches to monetary easing. Over summer, cyclicals began taking the lead and their outperformance accelerated with the election of Donald Trump and his promises of tax cuts and infrastructure spending. Our view that the global economy should expand by more than 3% in 2017 before accelerating in 2018 supports a positive outlook for stock markets, first of all thanks to the favourable impact on earnings growth and secondly because valuations are not a constraint. History even shows that cyclical leadership leads to a declining risk premium. Some revaluation is thus clearly not to be excluded, particularly when one takes into consideration the expensiveness of fixed income assets, the main alternative in the mind of investors.

Accelerating earnings growth will drive markets higher.

Some major headwinds are disappearing. First of all, the energy sector will now benefit from rising prices since January’s Brent low of USD28. Mining companies are in the same situation. Financial companies will take advantage of steeper yield curves and from declining provisioning needs; it clearly remains to be seen though whether they can improve their lending activities. These developments could bring global earnings growth to higher rates than the 5-7% implied by 3% global GDP growth. When one takes into consideration dividends, then equities could deliver total returns in the region of 10% in 2017.

Overbought conditions but nothing too worrying.

Cyclical sectors or small caps such as the Russell 2000 index show overbought conditions. Sentiment is complacent looking at the VIX and bullish looking at individual investors with the gap between bulls and bears close to 30% in favour of the former. These are elements that point to occasional bouts of rising volatility but within a trend that is up. The recent reversal of nearly six years of outperformance by defensive sectors is in our view the signal that animal spirits should finally revive and it should not take too long for 10 years of net money outflows from stock markets to also reverse and become positive.

A preference for pro-cyclical markets, such as the euro zone

It has been a serial disappointer over the last few years because of successive hits to earnings. The earnings disappointment relates first of all to sectoral problems in financials and in commodities. They make up 30% of the earnings underperformance versus the US since 2007.

Another 22% of the underperformance comes from operating margins. Another important factor is the more timid wave of share buybacks. Sales growth has also disappointed but to a much smaller extent. Looking forward, leading indicators draw a rosy picture and we indeed see growth above the long-term sustainable rate (of 0.9% according to Exane) in 2017.

In 2017, earnings should be able to grow between 5 to 10% on a combination of headwinds for financials and commodity sectors turning backwinds, of operational leverage and contributions from a stronger dollar. In terms of valuations, they are attractive based on cyclically-adjusted earnings, on the price-to-book ratio, on dividends and when compared to bonds. We are of course conscious that there is a heavy political agenda and that room for fiscal stimulus is more limited than elsewhere but these should be outweighed by the above “key positives”.

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).

A preference for pro-cyclical markets, such as Japan.

The endeavour of leading Japan out of three decades of deflation and recession is huge. Abenomics has brought several strongly positive developments but they have been masked by fiscal tightening between 2013 and 2015 equivalent to 3% of GDP. Among the positives is the marked improvement in ROE; it has been followed by only a timid revaluation with the price-to-book rising from less than 1 in 2012 to 1.3 currently. Japan remains very attractively valued in international comparison.

Catalysts for some re-rating are several. The first one lies with the prospect of a weakening yen, which we see going to 118 versus the US dollar by the end of 2017. The correlation between currency movements and stock market movements remains very tight. Interestingly, earnings have recently shown better resilience than implied by the strengthening of the yen, thanks to cost control and to domestic sectors of the index.

The second one is that earnings prospects are good also thanks to a high share of cyclicals in the index and to continued strong share buyback activity. Finally, investor positioning speaks for a favourable outlook as domestic investors have low equity exposure and foreign selling has slowed down.

US: Positive outlook thanks to earnings but below average upside potential due to valuations

Earnings have returned into positive territory in Q3 and are on an accelerating uptrend. Reflationary policies will lengthen the economic cycle and raise the EPS upside before the cycle top is reached.

Tax cuts will also add upside to earnings prospects. Capital repatriation might benefit mainly share buybacks, another positive for the bottom line. Not to be forgotten, commodity prices having recovered significantly from their January multi-year low they will now boost earnings for energy and mining companies.

The main constraints on earnings are increasing margin pressures, the strong dollar and rising protectionism, which might penalise input costs for US companies. If earnings prospects are good, the upside for the US stock market will be contained by 1) high valuations 2) a background of rising Fed funds rates 3) at a time when the US is the only market where dividend yields are lower than government bond yields.

Neutral stance on the UK.

Earnings had been expected to fall in 2016 but the sharp fall in the pound since the Brexit vote allows earnings to end the year flat versus 2015, as more than 70% of sales are generated outside of the UK.

Another reason is that the oil and materials sectors have benefited from rapidly recovering commodity prices. In 2017, the weakening of the pound will benefit exporters and the conversion of foreign earnings into the local currency but domestic sectors will suffer from hits to consumption from a 3% rise in inflation and from uncertainties about the conditions of the Brexit, particularly on the financial sector, which makes up 20% of the FTSE100 index.

Valuations are moderately supportive of UK stocks, between a dividend yield of 4% and a price-to-book of 1.8. Because of depressed earnings levels, the PE is high. All in all, with a hard Brexit in prospect, which will weigh on medium-term earnings dynamism, we are neutral on UK stocks.

Neutral on Switzerland, but positive on mid-caps.

Earnings have been declining in both 2015 and 2016. They should return in positive territory in 2017 thanks to accelerating sales growth, better margins and the waning of FX hits.

Dividend yields superior to 3% are a strong attraction but high PEs and limited cyclicality of Swiss large caps warrant a neutral stance. We remain however positive on Swiss mid-caps, which are much more cyclical, have faster earnings growth prospects, solid balance sheets and reasonable valuations.

Emerging markets: neutral ahead of Fed rate hikes and given protectionism risks; positive stance on Asia.

Fundamentals are improving with 1) some countries expected to keep accelerating (India, Indonesia), thanks to past reforms 2) others leaving recession behind and benefiting from basis effects (Brazil, Russia) and 3) with China’s growth rate stabilising above 6%. ROEs are stabilising but mainly due to cuts in productive capacities which allows an improvement in asset turnover.

Changes in the MSCI composition raise the attraction of emerging markets, with information technology’s share rising from less than 13% in 2011 to nearly 24%. Given that emerging markets are sensitive to the trend in the Fed funds rate, to rising bond yields and to a strong US dollar, we are neutral.

Given that economic surprises are better oriented in developed countries, this is another reason for favouring a neutral stance. Uncertainties about what policies the incoming new US administration will follow also comfort this preference for a neutral view. In terms of valuations, they are in line with long-term averages.



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