#Investments — 28.11.2016


Roger Keller


#1. The bull is ageing but will remain at the centre of the stage.

The current bull market will reach 8 years next March. It is the second longest in history but is not poised to die from old age yet. The background stays supportive. The global economy is expected to grow slightly faster than 3% for the 6th consecutive year in 2017. This is a subdued pace but it is sufficient to allow a 5-7% global earnings growth rate, which would represent an acceleration from this year’s 2% rate. Given that valuations are broadly neutral, equity markets should reach new highs in 2017. The election of Donald Trump as the 45th President of the United States creates a lot of uncertainties with regards to international relations but his tax cut and infrastructure spending plans are positive contributors to growth.

#2. Earnings are the key driver.

Absolute valuations for the global equity market are in line with their long-term average. Bull markets do not end simply with valuations returning to their long-term average; they usually reach expensive readings and euphoria reigns. We are clearly not there. Looking at relative valuations, they are favourable to equity markets. We would however not count on multiple expansion over the next 12 months as the anaemic character of the current economic cycle will rein in animal spirits. This is a way of saying that the 2017 equity market returns will be determined predominantly by the growth in earnings and secondly by the dividend yields. Earnings growth of 5 to 7% (versus a consensus view of +13%) and dividend yields slightly below 3% translate into high single-digit performances.

#3. We are probably more than half-way through the period of consolidation.

We saw mainly three categories of short-term risk for equity markets: political, economic and policy related. Political risks remain in place (US protectionism, Italian referendum next month, European elections in 2017…) but the probability of the most adverse scenarios has receded. Recent PMI surveys and leading indicators have been reassuring and the market is increasingly discounting a Fed rate hike in December, which is our core scenario. We believe that occasional bouts of volatility are much more likely than substantial setbacks.

#4. We favour pro-cyclical markets, such as the euro area.

The euro area has been a serial disappointer on earnings over the last few years, because of the impact of falling commodity prices on energy and materials sectors, because of strong structural headwinds for financial companies and continued deceleration in emerging countries. As a result, the trailing PE is high. Based on cyclically-adjusted earnings, on the price-to-book ratio, on dividends and compared to bonds, euro-area equities seem however attractive. We are positive on this region’s stock market because leading indicators point to a growth rate in line with the region’s long-term potential (slightly below 1%), because we see signs of stabilisation in emerging countries and thanks to the high operational leverage that characterises the EU stock market, not the least resulting from past cost-cutting efforts. Commodity-oriented companies will benefit from rising oil and base metals prices whilst financial firms should display a positive relationship with an expected modest rise in bond yields. The earnings catch-up story should finally begin to appear; we would however not count on double-digit growth rates at this stage.

#5. We favour pro-cyclical markets, such as Japan.

Japan’s key advantages are valuations, the most attractive among developed markets, and investor positioning, with domestic investors having low equity exposure. Foreign selling has slowed down. This market has the highest share of cyclicals in its index among major markets and is sensitive to China more than others. These are positives given our macro stance on the US, emerging countries and China. Our expectation of a moderate weakening in the yen is another plus, as are rising payout ratios, an improving ROE trend and share buybacks. Recently, earnings trends have shown better resilience than implied by the strengthening of the yen, thanks to cost control and to domestic sectors of the index. We see a mid-single-digit rise in earnings in 2017. What is needed to unleash a substantial rise in stock prices is news on reforms, to help improve productivity and potential GDP growth. These are slow in coming. Meanwhile, a substantial decline in fiscal tightening (equivalent to 3% of GDP over 2013 and 2015), rising employment and wages (moderate though), a resilient Tankan survey and recovering land prices all militate for keeping a positive stance on Japanese stocks.

#6. The US should be able to reach new highs but has below average upside potential.

It becomes increasingly clear that the trough in earnings has been reached in the first quarter. After five consecutive quarters of negative earnings growth, Q3 seems to bring flat results and Q4 should see a resumption of positive earnings growth, thanks to better revenue trends and fading headwinds (commodity prices and dollar). Worth highlighting is that ex-energy, earnings have been declining year-on-year in only one quarter (1Q16), which should correct the widely-shared impression of an earnings recession. 2017 promises to be a year of positive earnings growth, with the bottom line potentially boosted by corporate tax cuts but also penalized by rising wage costs. High valuations limit the upside of US stocks. We are neutral.

#7. Neutral stance on the UK and Switzerland (but positive on Swiss mid-caps).

Due to the 18% fall in the pound versus dollar, the earnings decline of FTSE100 companies in 2016 will in the end prove to be marginal. The solid return of UK stocks year-to-date is to be attributed mostly to the fall of the pound 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, which are expected to become marginal going forward. In 2017, the weakening of the pound will benefit exporters as well as 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, and given a highly overbought condition, we are neutral on UK stocks. In Switzerland, 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, we are neutral. We are positive on Swiss mid-caps, which are much more cyclical, have faster earnings growth prospects, solid balance sheets and reasonable valuations.

#8. Still neutral on emerging markets due to rising protectionism and to the Fed hurdle; positive stance on Asia.

Fundamentals are improving with some countries expected to keep accelerating (India, Indonesia), thanks to past reforms, with others leaving recession behind and benefiting from basis effects (Brazil, Russia) and with China’s growth rate stabilising above 6%. Because of overbought conditions, of the protectionist approach of the Trump administration 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.

The year-to-date solid progression of emerging markets is due to their close correlation with the trend in the dollar and in commodity prices: mid-January, investors began anticipating delays in the next Fed rate hike; the US dollar then began weakening and commodity prices rebounding; this lasted until mid-August, when expectations for a December rate hike began to grow, leading to a new phase of strengthening in the dollar and concomitantly to range-trading of commodity prices and ultimately of emerging stock markets.

The next phase of progression of the latter should be based on improvements in the return on equity, which has now stabilised. Earnings prospects are brightening because of base effects in energy and materials sectors and thanks to cost cuttings, which are improving operational leverage. 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%. For the time being, because economic surprises and leading indicators are better oriented in developed markets and before the next Fed rate hike, we prefer to retain our neutral stance. Asia is our preferred region, being a commodity consumer and with high exposure to technology stocks. In terms of valuations, they are in line with long-term averages.

#9. Style investing: buy value.

Growth stocks have been outperforming since 2006, on a global basis. They remain core holdings for the long term, in a slow growth environment. The relative performance of value stocks has stabilised on a global basis since the beginning of the year. In Europe, underperformance continued.

A period of outperformance is opening up in our view, in both the US and Europe, thanks to five drivers. These drivers are: attractive valuations, an expected rise in risk appetite, a coming acceleration in earnings growth, positive correlation with rising bond yields and high value dispersion within sectors.

#10. Style investing: euro-area SMID caps still offer an attractive diversification.

Given that domestic demand is the main driver of growth in developed countries and that we expect moderately rising bond yields, small cap stocks have room to perform nicely. European small caps are much more attractive than US small caps, being at an earlier stage in the cycle. We continue to like Swiss mid-caps for their above average earnings growth outlook, for the strength of their balance sheets and their pro-cyclical profile.

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