#Market Strategy — 19.09.2016

Equity Markets: Further Upside Over the Medium Term

Roger Keller


A good summer for equity markets in the end

Despite rich valuations, a lack of earnings growth, uninspiring macro trends and the presence of political risks over coming months (the Italian referendum in particular), equity markets made significant gains over July and August. Investors rapidly forgot the Brexit and focused on the improvement in positive economic surprises as well as on the prospect of increases in fiscal spending on top of new initiatives from monetary authorities. Finally, the earnings season has been reassuring

Fundamentals point to further upside over the medium term

We remain positive on the outlook for the global economy. This should allow earnings to resume climbing after the strong hit they received since the second half of 2014 from the collapse in commodity-related sectors. Another strong hit over the same period came from the substantial appreciation in the US dollar (mainly to US companies, which represent 53% of the global equity index, and to emerging markets). Earnings are expected to be the primary driver of stock markets going forward. This is because the reflationary policies followed since 2009 brought forward market gains – through what is called the “QE-induced portfolio rebalancing effect” - and thus led to relatively rich valuations, which is to the detriment of returns in coming years.

Conflicting signals from technical and sentiment indicators

On the one hand, stock markets are in overbought territory, complacency reigns looking at the VIX volatility indicator (despite important political appointments in coming months on both sides of the Atlantic) and September is statistically the worst month of the year. On the other hand, cash is abundant (5.8% of their portfolios according to fund managers), sentiment is neutral and … alternatives are few (TINA effect; TINA is for There Is No Alternative). Overall, near-term downside risks should prove limited to potentially a return to the 200-day moving average.

Still a preference for developed stock markets

The trend in economic surprises is more favourable in developed countries than in emerging countries. As we get closer to 2017 though, the growth differential between developed and emerging countries will turn in favour of the latter in our view. We should thus have in coming months the opportunity to become more positive on emerging stock markets as a whole and we would be able to broaden the range of emerging stock markets that we like beyond China and India. For the time being, signs of improvement in the relative growth potential are too tentative and we keep our preference for mature stock markets.

Emerging markets: how to interpret the solid returns since the middle of January?

Since their January lows, emerging stock markets have substantially outperformed, on a combination of rising commodity prices, some improvements in economic conditions, such as things not getting worse in Brazil and Russia, and expectations that the Federal Reserve will move cautiously with its plans to raise rates.

Going forward, a range-trading oil price will no longer be a positive catalyst. Expectations about Fed policy are shifting in favour of a nearer rate hike than anticipated. The implication is a rising dollar which is a negative for emerging stock markets. The credit impulse of emerging markets is negative currently. Trailing earnings in local currencies are not yet stabilizing. With valuations reflecting fairly well the fundamentals of emerging countries, we prefer to remain neutral and to wait for more signs of stabilization.

Beyond a potential phase of digestion of the July-August gains in the near term, stock markets remain well supported by fundamentals and should gain further ground over the medium term.


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