#Investments — 07.06.2017

Part 2. The relative merits of several stock markets

Roger Keller

Part 1 was dedicated to our directional views on stock markets. Here, we delve into the relative merits of the following six stock markets: the US, the euro area, Japan, the UK, the Swiss and emerging. The message that comes out from both parts is that, after a period of consolidation, we expect stock markets should be able to reach new highs, under the leadership of pro-cyclical markets.

US: limited upside, due to high valuations. We are neutral

Earnings prospects remain good, despite high margins and high levels of return on equity, as befits late stages of economic cycles. Earnings dynamism is however going to be affected by rising wages and a slowdown in share buybacks. The main constraint comes from valuations. All the ratios we look at express expensiveness. Maybe the one that worries us the most is the median PE: it stands at 24, a level that was in the past followed by extremely poor returns (and an average drawdown of 18% within the following three years). This should not prevent the stock market reaching new record highs before the end of the year, particularly if some tax reforms take place in 2018.

Euro area: firing on all cylinders, at last! We are positive

Companies enjoy a favourable environment with strong domestic trends as well as positive export prospects. After five years of going nowhere, earnings can finally resume with an uptrend and begin reducing their 24% gap versus their 2007 record high. In coming quarters, the prospects are rosy thanks to positive operating leverage, share buybacks and favourable base effects for financials and commodity-related companies. These drivers give the euro area stock markets above average upside potential, which should motivate foreign investors to make a comeback, all the more so as valuations are reasonably attractive (CAPE, P/B, dividend yield and relative to bonds) 

Japan is as prime beneficiary of reflation: we are positive

Earnings in Japan have surpassed their 2007 high thanks to their strong uptrend since 2013, which corresponds with the implementation of Abenomics and in particular of incentives to improve bottom lines. Potentially, this limits earnings growth potential but it is too early to worry on that. Earnings growth should be supported by growing signs of a return of inflation and by the positive trend in the global economy. This is of great importance for Japan as it is the most pro-cyclical market, having the highest share of cyclicals in the index.

Recently, domestic indicators have delivered promising signals and this should continue with the expected positive impact that should come from the fiscal stimulus enacted late in 2016. In addition, it is a market that performs usually well during periods when US bond yields rise, which we expect to happen. It also has a very strong negative correlation with the trend in the yen: as we expect the latter to decline, Japanese stocks should rise. Share buybacks should continue to support equities, as should institutional investor buying. Finally, valuations are attractive. The relative PE is nearly at its lowest since 1990 and the price-to-book is not reflecting the ROE improvements.

UK: a transitory phase of earnings dynamism: we stay neutral

Since returning to their 2008 high in 2011, earnings have been on a declining trend. Thanks to the sudden drop in the value of the pound in the middle of last year, earnings have been able to stage a significant rebound. The close relationship of earnings with the trend in the currency is due to the fact that 70% of revenues are generated outside the UK. This year, the strong rebound in commodity-sector earnings - sectors that represent 23% of the FTSE100 index - allows earnings to keep growing strongly but the strength of the currency, coupled with signs of growth deceleration in the UK ensuing from the uncertainties brought by the vote for Brexit, render consensus earnings expectations vulnerable to downgrades. With valuations in line with their long-term averages, we are neutral on the UK stock market, which is supported by a high level of dividend yield: 4%.

Switzerland: time to downgrade mid-caps. Neutral now on both large caps and mid-caps

The defensive nature of Swiss large caps led us to be neutral on them as we saw better opportunities for more cyclical markets. Since the middle of April, Swiss large caps have recouped lost ground as investors became less enthusiastic on the reflation theme and their return is in line with that of the MSCI World AC index. We stay neutral with valuations around long-term averages and the reflation theme likely to resurface later in the year. Mid-caps, on which we were positive, have however offered twice the return of large caps since the start of year: 18% versus 9% respectively. Over the last 5 years, mid-caps have delivered average yearly returns of 16%, which now results in a valuation premia among the highest seen over the last 15 years. Hence, we downgrade mid-caps to neutral. They remain an attractive asset for the medium term.

Emerging Markets: neutrality

Emerging stock markets have performed better than anticipated. First of all, leading indicators, economic surprises and earnings have allowed returns to be solid. The latter have then also been helped by the recent decline in bond yields, by the weakness in the dollar and finally by an absence of trade restrictions from the US. Going forward, we still expect the dollar and bond yields to strengthen whilst fundamentals seem less supportive, looking at leading indicators and economic surprises. Commodity prices lack upward momentum. Meanwhile signs are multiplying that China faces some moderation in economic activity in the second half, which should weigh on sentiment. Finally the reversal in China’s PPI has negative implications for industrial profits. Not to be forgotten is the threat of protectionist policies from the US at any time. With valuations in line with their long-term averages, we prefer to stay in such circumstances neutral, with an unchanged preference for Asia. 


The best upside over a 12-month horizon resides with pro-cyclical markets, i.e. the euro area and Japan.