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#Market Strategy — 04.07.2016

Stock market outlook

Roger Keller


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

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