#Investments — 10.04.2018

Equity markets: A volatile primary uptrend lacking catalysts in the near term

Roger Keller

Equity markets are driven by mainly earnings and valuations. The former are expected to drive markets up in 2018. The path should remain bumpy however.

Fundamentals point to an intact primary uptrend

The main driver of equity markets is earnings growth. Consensus expectations are for 14% growth in 2018 and 9% in 2019. Ours are more conservative but not that much lower. Based on the conviction that the global economy will decelerate only moderately in 2019 and that, with regards to corporate margins, they will stay well defended in the US while they keep improving elsewhere, earnings should continue to expand faster than sales for the foreseeable future. Comforting our view is the broad base of contributions to earnings growth. In addition, history teaches that bull markets do not die from old age but from the exhaustion of earnings growth potential, which is clearly not on the cards, among others because central banks remain very alert to downside risks to growth. Implicitly then, the message from these comments is that we do not expect trade tensions to escalate to trade wars that would have a significantly negative impact on economic and earnings growth.

An upside closely aligned to the rate of growth of earnings

The other major driver of equity markets is the expected change in valuation levels. Currently, valuations are moderately above their long-term averages, particularly when adjusted for the excesses of the tech bubble era. Considering that central banks are slowly retreating from ultra-accommodative policies and that bond yields are on a rising trend, valuations are unlikely to expand in the coming 9-to-12 months. Hence, the upside for equity markets in 2018 is closely linked to the global earnings growth rate. In concrete terms, we would expect the MSCI World AC index to rise by nearly 10% in 2018, before continuing towards higher levels in 2019.

A lack of catalysts in the near term

Real money growth keeps decelerating. This heralds that leading indicators such as the PMI surveys will deteriorate over the next few months, something that the global manufacturing PMI has already begun doing. The message coming out from the diffusion index of leading indicators is the same. Meanwhile, economic surprises keep disappointing consensus expectations. We remain convinced that in the end these deteriorating trends will prove to be mild and that fundamental indicators will continue to point at solid growth. In the meantime, investors will remain doubtful, which will weigh on the stock market trend.

Volatility should remain elevated

The combination of strengthening inflationary pressures and rising bond yields with slow shifts in central bank policies towards less accommodation and the loss of economic and earnings momentum creates a wide-ranging selection of headwinds. In addition, some widening in high-yield spreads and negative implications from technical indicators such as the weekly MACD indicator militate for further stress in equity markets. We remain of the view that downside risks remain limited by the solidity of underlying fundamentals. The logical outcome would therefore be the continuation of volatile trading sessions in coming months. This is indeed our core scenario. Investors should thus be opportunistic and look for taking advantage of volatility to buy stocks at attractive prices.

Bottom line

The bull market might seem to have reached a mature stage but it still has a lot of resources to keep going. Investors in equity markets should remain invested as long as they accept higher levels of volatility.