#Market Strategy — 06.04.2017

World equities: expect a period of volatility before the uptrend can resume again

Roger Keller

With the bull market entering its 9th year of existence, is it time to get concerned? We do not believe so but a period of consolidation is likely before the primary uptrend can carry on.

Eight years of bull market and counting

The bull market entered on March 9 its ninth year of existence. It is the second longest bull market in history but this longevity is no cause for concern as long as the economic background stays supportive. This is our core belief as we expect world GDP growth to be faster than 3% for the sixth consecutive year in 2017, and this should continue to be the case also in 2018. If this trend continues beyond June 2019, then it would become the longest period without a recession since 1850, based on US data.

An expected short-term pause in a primary uptrend

Despite our favourable view on the world economy and the resulting expectation for accelerating earnings growth, equity markets are likely to make a pause in the short term. They have been led into overbought territory by an impressive series of positive data. The harvest of good macro news has rarely been that good; it can now hardly become better than that. Noteworthy is the presence of a gap between soft data, i.e. data based on surveys, and hard data; there is a need for the latter to confirm the former and a risk that reflation hopes have gone too far. In addition, complacency has never been that elevated based on the relationship between the S&P500 forward PE and the VIX (an index of market estimate of future volatility).

Other elements pointing to a period of consolidation or correction is the appearance of negative divergences on the RSI and negative readings on the MACD. Political risks are also not to be dismissed, both in the US (on the size and timing of pro-growth initiatives and on protectionism) and in the euro area (elections).

Consolidation or correction?

Our preferred hypothesis for the near future is that volatility takes the form of consolidation with prices staying above their 200-day moving average as too many investors have relatively low weightings in equities and will increasingly feel the pressure to rotate out of fixed income assets into equities. Their animal spirit is likely to firm over time as hard data confirm leading indicators.

Should stock indices nevertheless go below their 200-day moving averages (6% below current levels at the time of writing on the MSCI World All Countries index) this would be for a short period of time, as is usually the norm when this happens whilst the 200-day moving average is in rising trend.

A positive medium-term outlook based on rising earnings

Our central view is that the outlook for corporate earnings in 2017 is good, thanks to some acceleration in global growth and broadening of its drivers beyond consumer spending. With global sales growth accelerating from last year’s 0% to an expected 5% this year, earnings can expand by approximately 10%. Such an outlook is derived from the combined contribution of positive operating leverage, share buybacks as well as reversals in fortunes in the energy and financial sectors. The energy sector alone could add to total market earnings growth at least two percentage points.

In the face of valuations that are either around long-term averages or above and given a series of rate hikes by the Federal Reserve, at least until the end of 2018, we see valuations remaining stable or slightly lower over the next twelve months. This matches historical evidence, which shows that 94% of the time, valuations undergo some derating. In other words, the upside of stock markets is very closely tied to the upside potential for global earnings. Thanks to dividend yields of 2.5% on average according to the MSCI World All Country index, the total return of equity investments over 2017 could be close to 10%.