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#Investments — 07.02.2017

Short-term volatility risks versus medium-term upside

Roger Keller

The global economic outlook has brightened and deflation fears have receded. Bond yields are as a result on a moderate uptrend. What awaits stock markets in coming months?

Solid fundamentals

We believe that we are at an intermediate stage of the bull market in equities. This is the period when fundamentals are the key driver of stock prices, not sentiment. The background being reflationary, this is positive for sales growth and earnings prospects, which benefit from operational leverage. Given that central banks are slowly shifting towards less accommodative policies, valuations will be unable to expand.

This means that earnings will be the primary determinant of returns in 2017. We see room for earnings growth close to 10%, based on operational leverage, which should contribute 5 to 7 percentage points to our expected earnings growth. Then the latter should see share buybacks adding another 2% percentage points and the rest comes from the energy and financial sectors. Dividends will continue to play an important role in the total return.

Technical and sentiment constraints over the near term

The MSCI World index is trying to overcome its May 2015 record high level. The index is in overbought territory, shows some negative divergences and complacency reigns with a Vix index well below 12. A period of volatility should thus dominate in the short term. Catalysts for a bumpy ride are likely to be related to political or geopolitical developments as fundamentals are reassuring. Conditions for substantial setbacks are not in place with investors having been net sellers of equities over the last 10 years and accelerating uptrends in 200-day moving averages. Investors should refrain from being too aggressive with their purchase price targets.

US: further new highs to be seen; we stay neutral because valuations limit the upside

There is no doubt that US stocks are expensive. This is the reading of measures such as PEs, the P/B, the cyclically-adjusted PE or the median PE. The dividend yield also points to expensiveness as it stands below the yield on the 10-year Treasury bond. This is a unique case among the countries that we follow. Fortunately, when inflation is between 1% and 3% then valuations can remain elevated. We believe new highs will be seen thanks to an estimated 8% rise in earnings, which could prove conservative depending on the significance of tax cuts.

Such an outlook is based on the view that 5% revenue growth is probable, that the repatriation of foreign earnings will sustain share buyback activity and that the energy sector contributes positively this year (from a very low base). We are not seeing double-digit earnings per share growth because we expect negative impacts from a slight deterioration in margins and a strong dollar.

Leverage to the cycle gives the euro area above average potential

We favour the euro area within stock markets. Earnings are progressively recovering from cyclically-depressed levels, after having been hammered by a long series of negative factors. The most prominent of them are the damage to earnings inflicted on energy companies by a plunging oil price between mid-2014 and the end of 2015, structural problems for financial companies and poor operating margin trends. Lower share buyback activity than elsewhere was another main reason.

Thanks to their strong leverage to the global cycle and strong contributions expected from the commodity and financial sectors, euro-area companies should be able to deliver earnings growth close to 10% in 2017. The combination of a favourable earnings outlook with attractive valuations (CAPE, P/B, dividend yields and relative to bonds) should allow euro area stock markets to deliver above average returns.

The risks related to the heavy political agenda in Europe in 2017 are well recognised by investors, based on stock price behaviour that has not reflected the resiliency of euro area economic activity compared to the rest of the world. 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).

Japan: another prime beneficiary of the global reflation trade

Japan stock indices have the highest share of cyclical stocks among the countries that we follow. That is a key advantage at a time of growth acceleration in the global economy and with a growth outlook for Japan in line with its long-term sustainable growth rate. The Japanese yen is expected to weaken because the Federal Reserve will raise rates over coming quarters whilst the Bank of Japan will keep its rates unchanged and will try to keep the 10-year yield on government bonds around 0%. This is positive for Japanese stocks as they are very sensitive to currency fluctuations.

They rise when the currency weakens. The latter will support earnings growth. Given that the currency trend leads by three months the trend in earnings revisions, the recent improvement in the revisions index should continue at least until March. Earnings growth will also be helped by continuous improvements in corporate governance, which allowed earnings to be more resilient recently than implied by the first half jump in the yen versus the dollar. Share buybacks should stay strong and foreigners are likely to return to Japan given all the above dynamics.

Given their low equity exposure, domestic investors should also feed the uptrend in coming months. Valuations remain attractive with a relative PE nearly at its lowest since 1990 and the price-to-book not reflecting the improvement in the ROE of companies.

UK: neutral stance kept

With more than 70% of sales generated outside the UK, the outlook for the currency is a key determinant of earnings prospects. A lot of uncertainty surrounds the potential currency paths, as the Brexit process will be long and tortuous. Our base assumption is of a slight appreciation as a lot of caution is already priced in.

The impact on earnings would thus be mildly negative. Among the non-domestic sectors, materials and energy have a solid earnings outlook, which is already well taken on board by investors in the case of the former. The other non-domestic sectors either face uncertainties, such as financials with the question marks around the effect of the Brexit, or are defensive in nature, hence susceptible to neglect by investors. Looking at domestic sectors, they are vulnerable to the negative impact of rising inflation on consumer disposable income or to the Brexit uncertainties.

All these trends leave us with the prospect of below average earnings growth. Thanks to a 4% dividend yield and a moderate price-to-book ratio, UK stocks are well supported. The upshot is that UK stocks have only limited upside potential in 2017. We stay neutral.

Neutral on Switzerland, but positive on mid-caps

Mid-January, two years will have passed since the abolition of the minimum exchange rate. The country slowly recovers from this shock. Leading indicators point a rosy picture. A lot will depend on whether the Swiss franc will be forced to play its safe haven role or not. Our base scenario sees a benign environment with key rates unchanged for at least the next 12 months.

Earnings are expected to grow again, after two years of decline. For equity investors, the fact that the global economy is accelerating and that bond yields are rising means that the Swiss stock market is likely to underperform, due to its defensive composition. In terms of valuations, strong support comes from the dividend yield, around 3.5%, but the price-to-book and the PE are around their long-term average. All in all, we stay neutral. On mid-caps however, we remain positive.

They benefit from the global reflation trade, have strong earnings growth prospects, solid balance sheets and reasonable valuations.

Emerging markets: staying neutral

This year, the growth differential between emerging and developed countries turns in favour of the former, thanks to countries such as Brazil and Russia leaving recession behind, to China continuing to grow by more than 6% and to India which keeps accelerating. 2017 is likely to be also the year when the return on equity stabilises and slowly resumes an uptrend.

That is a major consideration with regards to the relative performance of emerging markets. Over coming months however, there are several hurdles. Historical observations show that emerging markets tend to underperform when the Federal Reserve raises interest rates, when the dollar strengthens and when bond yields rise. In the current cycle, another headwind comes from the political side, with the United States adopting protectionist views.

Rising tensions in the South China Sea must also be followed closely and may push investors to ask for a higher risk premium. Looking at valuations, they are broadly in line with their long-term averages when looking at the prospective PE, the price-to-book ratio or at the PE or price-to-book relative to developed countries. The dividend yield of 3% is however attractive. The bottom line is that we remain neutral with a preference for Asia, where there are growth stories such as India, beneficiaries of good demand trends in developed countries and where China is attractive from a long-term perspective.

Read our detailed analysis on our Voice of Wealth app available from the App Store and Google Play