#Investments — 11.07.2017


Roger Keller

Near-term caution versus medium-term optimism

The first half of 2017 has delivered one of the best stock market returns of the last 20 years. The bar is high looking at valuations. What is the outlook for the second half? We highlight also our style preferences.

Lacking catalysts over coming months

The first half saw equity markets capitalising on strong leading indicators, positive economic surprises and earnings revisions that had not been so good since 2011. As a result, equities have already delivered most of the returns we expected over 2017: we had tabled on price gains in line with the average global earnings growth, which we projected to be around 10%. We still expect 10% earnings growth for this year.

Now, the environment is characterised by some erosion in leading indicators, substantial deterioration in economic surprises and heavily overbought conditions. Coupled with relatively stretched valuations, these are factors that will weigh on equities in coming months. Thanks to the abundance of liquidity, easy monetary conditions and cautious positioning of investors after years of heavy flows into bonds but none, on a net basis, towards equities, downside risks are limited. They are also limited by the underlying healthy condition of the world economy.

All in all, we expect a period of consolidation, which could lead to a return to the 200-day moving average area, before the next phase of positive momentum starts, later in the year. It would be based on investors peering into the promises of 2018. Our investment stance is neutral over the near term and positive over the medium term.

Continuing earnings growth will lead stock markets to new highs later in the year

With global growth being synchronous, broadly based and with none of the excesses that usually mark the very late stages of any economic cycle, we remain confident on earnings growth prospects for 2018. At this stage, we see them growing at a high single-digit rate thanks to high operating leverage and despite limited pricing power. This is likely to lead to progressive capitulation by investors who had remained cautious over the last few years and therefore to rising inflows into equities. As fund inflows accelerate, some revaluation potential would then be unlocked. The best upside will reside with the stock markets most sensitive to economic conditions. They are the euro area and Japan.

Style investing: a preference for value, but with selectivity

Our core scenario retains acceleration in earnings growth in 2017 and rising bond yields. In other words, we believe in the success of global reflation; this should support animal spirits in coming quarters and in the end outperformance by value stocks. In the short term however, because of the stabilisation in leading indicators, reversal in economic surprises and absence of threats from inflation, we expect a period of volatility; value investing might thus not make much headway. Since we also like two classically growth sectors, i.e. healthcare and technology (beyond the near term), the best characterisation of our style investing preferences remains that we like believable growth and selective value. In the later, our focus is on energy and EU financials.

Style investing: still positive on EU mid-caps and neutral on US mid-caps

As the bull market enters a relatively mature stage, the question about lightening exposure to small/mid-caps arises. We believe that conditions for outperformance are still in place in the euro area as global growth accelerates and earnings momentum improves. In the US however, we are neutral because of valuation, which is at a premium of more than 50% versus the S&P500 and because high yield spreads become vulnerable after substantial deterioration in the health of corporate balance sheets; usually, this is accompanied by small cap underperformance. On Swiss mid-caps, we turned neutral last month.