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#Investments — 13.10.2016

Stock market preferences for october

Roger Keller

OCTOBER UPDATE

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New highs still likely but better upside elsewhere.

We fully agree with the consensus that earnings have troughed in the first quarter and we expect resumption of a positive trend in 2017.

Companies should be able to defend their margins but high valuations and the objective of the Fed to reduce accommodation should constrain the upside to marginal new highs.

Earnings acceleration and attractive valuations.

After several years of earnings disappointments - due mainly to the impact of falling commodity prices on energy and materials sectors, to strong structural headwinds for financials and to continued deceleration in emerging countries – the outlook is improving.

First of all, operational leverage is significant. Then, the basis of comparison for energy and materials companies will improve and self-help will impact their bottom lines positively. Another positive element is an expected gentle rise in bond yields, which should alleviate pressure on financials (which trade at similar valuation lows as during the global financial crisis and during the Sovereign Debt Crisis).

Finally, stabilization and progressive improvement in the emerging countries’ outlook will benefit EU stock markets as they are very sensitive to the global economic cycle. The growth in the bottom line will however be single digit, as the EU area witnesses some deceleration in economic activity. Valuations are supportive looking at the price-to-book, at dividends and considering that earnings are at cyclically depressed levels.

Modest preference within the EU for Germany; hold Italy and Spain.

Germany benefits from solid domestic demand trends, improving prospects in emerging countries and from the accommodative ECB stance. Its valuation is attractive. Currently, the market expresses serious concerns about Deutsche Bank, even considering whether there could be systemic risks. We believe that this specific situation is manageable (strong liquidity condition, possibility of liquidity provisioning from the ECB, possibility to redress the situation through bail-ins…). Elsewhere in the euro zone stock market, we do not see any more reasons to differentiate Italy and Spain from France and the Netherlands.

On Italy, we see on the one hand attractive valuations, partly justified by a low ROE and partly explained by the political uncertainties that come with the referendum. There is room for positive news on the banking sector and on the acceptance of the budget by the European Commission. On the other hand, the outlook for consumption, a bright spot until recently, is deteriorating as the backwind for consumers from a low oil price and fiscal measures is likely to fade. All in all, and given the outlook for economic deceleration, we prefer to recommend keeping positions and not to single it out from the rest of the EU.

The same reasoning applies to Spain, where in addition fiscal tightening is on the horizon, once a government is finally formed.

Conditions for an upturn in inflation expectations are being put in place by the BoJ with its new policy of controlling the yield curve and of targeting an overshoot in inflation by expanding the monetary base as long as it will be necessary.

Such a policy will keep real yields low and should the government increase its spending, as we expect, it will have limited impact on yields as the BoJ would be forced to buy. This would weigh on the yen, a positive for Japanese equities. Meanwhile, the negative impact of past yen strengthening should slowly fade as time passes and the earnings momentum is improving. Valuations are attractive with a prospective PE around 13 times and a price-to-book ratio of 1.1 times.

We still expect new initiatives by the Abe administration to stimulate activity and reform the country. Such news is likely to be the needed catalysts for a recovery in Japan’s stock market.

Still a high level of uncertainties...

The more than 10% fall in the British pound after the Brexit vote has improved the earnings outlook on the FTSE100 index, as more than 70% of earnings are generated outside of the UK.

Over 2016, the earnings decline will be marginal thanks to this currency effect. In 2017, the weakening of the pound will benefit exporters and the conversion of foreign earnings into the local currency.

These positives will be partly compensated by hits to domestic-oriented sectors. On balance, the earnings outlook could be above average but for the time being uncertainties remain elevated as confidence has plunged and the fog is thick with regards to the timing of the use of Article 50 that will initiate the Brexit process. With valuations high on a PE basis, admittedly on depressed earnings levels, and essentially fair based on the price-to-book ratio, we retain a neutral stance. Dividends are a strong support, as they stand above 4%.

Risk that recent improvements are only transitory

Signs of improvement in fundamentals keep coming: the composite PMI is on a rising trend since one year now, earnings estimates are upgraded, thanks mainly to the energy and materials sectors and the ROE seems to reverse trend.

Still, most of the improvement is related to rising commodity prices and the use of leverage to improve ROEs. We would be more positive if there were improvements in margins or asset turnover, if the credit impulse was not deteriorating, if consumption and services in China were the drivers behind its GDP growth stabilisation above 6% and if the next rate hike by the Fed was not entering the radar screen.

As we expect markets to witness higher levels of volatility in the autumn, we retain our neutral stance. Finally, valuations relative to developed stock markets are around their long-term average.

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 I 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.

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.

2017 should prove to be the sixth consecutive year of global economic expansion by at least 3%.

Once investors become convinced that downside risks won’t materialize, their risk appetite should rise and would favour higher beta stock markets, i.e. the Euro area and Japan, which are our preferred developed stock markets.

Such an environment would also be favourable to value stocks. Small/mid caps would also be sought after, particularly in the euro area and in Switzerland. In emerging countries, Asia has our preference.

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