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#Market Strategy — 04.07.2016

Stock market outlook

Roger Keller

Context

Higher volatility for longer

We had been expecting a phase of volatility in coming months because of:

  • Rich valuations (earnings-based valuations are around their highs of the past decade and the price-to-book ratio is around its 10-year average)
  • A lack of earnings dynamism before late in the year
  • A likely prolonged absence of clear message from economic indicators.

After the vote for Brexit, this phase of volatility is likely to be more pronounced and to prevail for longer. There are two reasons: a negative economic impact, mainly for the UK and, to a lesser extent, the euro area, and the inclusion of a wider political risk premium.

The latter is not only for taking into account that exit negotiations will be a very long and exhausting endeavour but also to incorporate the fact that within the European Union anti-establishment movements will feel emboldened and that the domino risk is not nil. 

Walking on a tightrope but still expecting higher markets in the medium term

Because valuations are rich in absolute terms, the outlook for stock markets is heavily dependent on the capacity of earnings to progress. This is our core assumption and is based on the view that the global economy will keep expanding, at a mediocre pace admittedly. This is sufficient to expect some acceleration in earnings growth in 2017, thanks to improving margins outside of the US and thanks to upward revisions in earnings expectations for the energy sector, after the relatively rapid return of the Brent oil price to the USD 50 area. Mid-single digit earnings growth is our expectation.

The upside potential in this core scenario is clearly constrained. Were the global economy not to remain on its growth tracks, then downside risks would be significant, because of the combination of significant downgrades of earnings estimates with a significant derating. There is an asymmetric relationship between risk and reward but given the paucity of opportunities, investors need either to accept higher levels of risk or that they achieve no returns. Dividends are expected to be key contributors to the return of equity investments. 

Busy going nowhere… fast, part two

We clearly do not see what could be positive and lasting catalysts over coming months, as economic and political uncertainties linger, valuations are rich and earnings will be slow to develop a positive momentum. We are encouraged in believing that downside risks might be limited by the improvement in the relationship between upward and downward earnings expectations, by the presence of poor sentiment, by the cautious positioning of investors, as reflected in the 5.7% cash level in the BoAML fund manager survey. Worth highlighting is the rotation out of equity funds into bond funds that has been the strongest since early 2009 according to JP Morgan. Also of interest is the observation that hedge fund redemptions in Q1 have been the worst since 2009. Of course, we cannot exclude that the lighter trading volumes during summer, coupled with further deterioration in sentiment, lead prices to new and temporary extreme lows. The above-listed elements plus the strong support coming from dividends, which have rarely been as attractive compared to bonds in several decades, and the vigilance of authorities provide good chances that this does not occur.

Preference for developed stock markets in a context of risk aversion.

The rapid recovery of emerging markets since their January 21 low has proved being nothing else than an oversold rebound. Its main driver has been a reversal in the oil price starting on the same date. With the vote for Brexit, the prospect for Fed rate hikes has been postponed again without triggering new weakness in the US currency, as it plays its safe haven role. Because we expect uncertainties to prevail in coming months, we believe that risk appetite will stay low. This would be to the detriment of emerging markets even though the latest source of global market turbulence is found in developed countries. Finally, question marks about whether China benefits only from a positive mini cycle remain. In such circumstances, we prefer to keep our preference for developed markets. 

By countries

"Still room for outperformance"

After the Brexit vote, the growth outlook for the euro area has to be downgraded slightly and a wider political risk premium has to be added (Italian referendum, Dutch elections, French election…).

Fundamentals stay sufficiently resilient to expect the earnings dynamics to be above average, as they are still at cyclically-depressed levels. Over time, euro area stocks will in addition benefit from a progressive improvement in emerging countries’ growth, as they are leveraged to the global cycle.

The above average valuation readings on the PE or the P-to-EBITDA should not be given too much weight given that earnings are at cyclically-depressed levels; a preference should be given to valuation tools such as the price-to-book, dividends or comparisons to bond valuations. The latter is all the more attractive as monetary policy will stay ultra-accommodative for a considerable period of time still. A progressive move of the EUR/USD parity to 1.08 should also contribute to the positive outlook.

 

"Positive stance maintained whilst waiting for Abenomics 2.0"

Corporate earnings have recently suffered a significant hit from the sharp appreciation in the USDJPY from an average of 120 over 2015 to the 102 region currently.

Receding risk aversion and policymaker initiatives should drive to a new phase of yen weakening.

This should improve earnings prospects, which will also benefit from a 3 percentage points boost in 2016 coming from a lower corporate tax rate, from reductions in special charges (restructuring and asset impairment), from continued share buybacks and from a slight improvement in exports.

The Abe administration is expected to make several announcements over coming months to help reinvigorate Japan’s economy: after a frontloading of fiscal spending, the postponement of the sales tax increase planned for 2017 to 2019, supplementary budgets are on their way and structural reforms will continue.

Finally, with a forward PE slightly above 13 times, valuations are attractive.

 

 

"Neutral: not much upside as the cycle becomes mature"

The drag from the slump in the oil price and from the strengthening in the US dollar should slowly fade, as the former has seen its price return to the levels that prevailed last autumn and the latter is in a range since last spring. Unsurprisingly then, consensus net revisions have recently turned positive, also thanks to the fading fears of recession.

The first quarter of 2016 has probably seen the worst phase in the profits cycle and earnings are likely to return into positive territory in the second half, before they accelerate somewhat in 2017.

They should grow at a single-digit pace due to a lack of pricing power and due to margin pressures intensifying. The combination of rising pressures on corporate margins, high valuations and loss of leadership as the Fed looks for raising its key rate again leaves us with a neutral stance on US stocks.

Finally, the releveraging of balance sheets done by companies over the last few years limits their capacity to be as generous on share buybacks going forward. 

 

 

"Remaining neutral after the Brexit"

The 11% fall of the pound sterling against both the US dollar and the euro boost the outlook for earnings, through the transactional and translation effects on the bottom line as 70% of sales are generated outside the UK.

30% of those revenues come however from the emerging space, where prospects stay very uncertain. For the 30% of sales that are domestic sales, their outlook has been tarnished by the Brexit vote, which will hurt domestic economic growth.

Given how uncertain the Brexit process will be, a political risk premium is necessary. Given that the prospective PE stands at close to 15 times, UK stocks are clearly on the expensive side of their 10-year history.

They trade at a premium to the rest of the world, which is a rather rare event. 

 

 

"Staying neutral, uncertainties abound"

The first reason for remaining neutral is the uncertain macro outlook, well reflected in economic surprises, whose profile is worse than for developed markets, and in China’s PMIs which straddle the 50 expansion/contraction line. We also notice that rating downgrades on EM debt are at their worst in 6 years, as are the number of issuers at risk of downgrades by Standard & Poor’s.

A second reason is that further impulses from commodity prices are now most likely to become much scarcer.

A third reason is the increase in risk aversion as expressed by the strengthening of the US dollar. Looking at valuations, they are either in line with the 10-year average when looking at the 12-month forward PE of 11.5 times or reasonably attractive when looking at the price-to-book, which stands at 1.4 times.

Finally, we would need to see stabilisation in earnings prospects before looking to upgrade our opinion.

 

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