Bad Geopolitical Context And A Good Economy... What Is The Impact For The Stock Markets?

After a strong rally in the first half of the year, stock markets might suffer from a less buoyant context over the next couple of months. Indeed, a number of factors could penalise equities: stretched valuations, fewer pleasant economic surprises, a more moderate pace of upward earnings revisions, and finally, some complacency on the markets, reflected in the currently narrow spreads of High Yield bonds and the low implied volatility.

These factors, in place for several weeks, should theoretically trigger a correction on the stock markets. And yet, they remain extremely resilient. The MSCI World index was still at an all-time high at the beginning of August. Investors are convinced that there are more opportunities out there. For example, they are attracted to the solid growth in technology stocks.

However, the deterioration in the geopolitical context might change market sentiment. Actually this might become a pretext for investors to take profits. In this environment, we prefer to keep a cautious stance on equities in the short term. Although a more defensive sector strategy makes perfect sense in view of “macro-technical valuation” criteria, some themes still have attractive potential:

1) Domestic demand in Europe: The economic cycle remains—and will remain—favourable thanks to a good dynamic in demand within the eurozone. However, we diversify our positions by favouring both cyclical (banks, infrastructure) and defensive (telecoms) sectors. Long shunned by investors, telecom stocks will benefit from high dividends (secured by cuts in investment spending), rising revenues and attractive valuations.

 2) Commodity-based stocks. Oil stocks will benefit from the expected stabilisation in the Brent at $50-60. Higher prices will allow commodity-based companies to distribute cash dividends once again. Moreover, they continue to trade at attractive valuation levels. Investors with a higher risk profile could diversify their positions in mining stocks, although the latter remain much more dependent on the Chinese economy than oil stocks.

Sector and regional strategies are very reliant on the dollar’s movements

In recent weeks, two events have taken the stock markets by surprise. The first is the euro’s ascent; the second is the good economic news from China. These two events have a major impact on the regional and sector allocation. On the one hand, the rise in the euro has penalised European stocks that are exposed internationally, because they are particularly sensitive to currency movements. Other sectors that have taken the brunt are capital goods, automobiles and consumer staples.

On the other hand, the good macro figures in China and the decline in the dollar have given emerging stock markets a new momentum. A more gradual monetary tightening by the Fed, a stabilisation in emerging market currencies (which gives local central banks more leeway for their monetary policy) and good Chinese data (which drive up commodity prices) are usually favourable to the emerging markets. Moreover, companies in this region are showing a higher return on equity (RoE) on the back of better economic growth and their own efforts.

We address two relevant questions:

1) Should investors return to the emerging markets? The riskiest emerging markets (Latin America, certain European markets) have ridden the wave of the renewed interest in the region. Nevertheless, they are vulnerable to a dollar reversal (a rebound is expected in the short term) and are exposed to specific risks which are not fully priced in (credit in Turkey, political in LatAm). We continue to like Asia for its more solid economic and financial fundamentals. With less credit, China is set to grow at a more moderate pace in the coming years, although the Chinese authorities will endeavour to curb any financial instability (excess debt, credit risk) while keeping appropriate lending conditions in a bid to limit an economic slowdown.

2) What about buying European stocks that perform better in the context of a weaker euro? In view of the anticipated fall in the euro, global stocks are likely to post a rebound. However, we note that they are still trading at high valuation levels. Except for automakers, the most internationally-exposed sectors in Europe show much higher price-to-earnings ratios than their long-term average. We consider it too early to return to this theme, particularly at the beginning of a stock market consolidation.

To conclude, today’s market conditions call for caution. The positive factors are well known and have been largely priced in. After the strong rally in recent quarters, the markets need to take a breather. It is therefore essential that investors reduce the risk and focus on robust themes.