#Market Strategy — 06.04.2017

Better upside for the Eurozone and Japan stock markets than for US equities

Roger Keller

The US stock market has been a star performer over the last few years. Can it keep delivering above average returns or is it time for other stock markets to take the relay?

We believe that the EU and Japan have the capacity to take the leadership, as they offer better earnings momentum going forward.


US: staying neutral given limited upside potential

We still see the US stock market reaching new record highs but they are unlikely to lie significantly higher than the 2400 that was nearly reached at the beginning of the month of March. The main culprits for this limited upside are twofold: extremely high valuations - however one looks at them - and constraints on earnings growth coming from wage increases.

Consensus estimates on 2017 earnings growth have been revised down since the beginning of February by USD 3, or by more than two percentage points. There are further downside risks as investors downgrade their expectations for the size and timing of benefits coming from tax reforms, at least in 2017. For 2018, prospects remain good, thanks to the implementation of the tax reform, on top of continued growth in operational earnings.

Euro-area: potential to outperform thanks to its pro-cyclical profile

Leading indicators paint a rosy picture for the euro area: the IFO survey reached its highest level since the middle of 2011 and the composite PMI kept rising, to reach its highest level in nearly 6 years. The favourable trend in monetary aggregates allows counting on continued high levels of positive readings in leading indicators.

These developments – together with a decline in political concerns - helped reduce investor resistance to buying the region’s stock markets. Concomitantly, analysts and strategists are upgrading their 2017 earnings estimates, to take into account the high level of operational leverage in the region, the positive prospects for energy companies coming from higher levels of crude prices as well as favourable impacts on banks from rising bond yields, without forgetting the room for more significant share buybacks.

The combination of all these factors with attractive valuations (CAPE, P/B, dividend yield and relative to bonds) should allow euro area stock markets to deliver above average price progression.

Because Germany benefits from monetary conditions too accommodative for its own fundamentals, domestic demand trends are solid. Given its high cyclicality and exposure to emerging countries, this is a market that should keep outperforming within the area. Its valuation is attractive (but it is true that it appears so thanks to the solid rise in earnings seen over the last few years).

Keeping our positive opinion on Japan

Since the beginning of the year, the Japanese currency has strengthened by 5%. Over the same period, economic surprises have deteriorated and the composite PMI has weakened somewhat. These trends explain the flat behaviour of the Topix over this period.

We nevertheless believe that the outlook remains good, based on the strong improvement in real M1 – which usually leads real GDP growth by 6 months – based on other indicators such as those on the job market and our expectations of a weakening in the Japanese yen.  In addition, global reflation is a great advantage for Japan, as it has the highest share of cyclicals in its equity index among the countries that we follow, has high operational leverage and as the good correlation with rising bond yields testifies. Share buybacks should stay very well oriented and investor demand has improved looking at fund flows.

Valuations remain attractive with a relative PE nearly at its lowest since 1990 and the price-to-book not reflecting the improvement in the ROE of companies. Finally, the 200-day moving average has reversed trend last December; it is now again in an uptrend.

The Eurozone and Japanese stock markets are positioned to benefit better than the US from a global economy that is expected to keep growing.