Fundamentals such as economic and earnings data remain very supportive of equity markets, but they are counterbalanced by geopolitical tensions and less supportive market behavioural dynamics. This warrants a somewhat more cautious stance on equities.
11.09.2017 | 08:04 Uhr
The news flow of the past few days is dominated by North Korea and the impact of hurricanes Harvey and Irma. It is noteworthy that the impact of the former on equity markets is becoming less and shorter in time, despite the escalation of tensions. The rhetoric is explosive, but in the end we think sanctions will remain limited to administrative ones and trade restrictions. Investors hope that in the end all parties will remain sensible and that also this geopolitical storm will eventually calm down. Of course, these risks are part of our assessment of market dynamics and are taken into account in our market views. This means that the strong fundamentals which would justify a more positive stance on equities are counterbalanced by these risks. Let’s recapitulate.
Macro data remain strong, inflation low
First of all, the macroeconomic data have in general surprised to the upside over the past month. Although real growth data have been revised upwards, inflation remains stubbornly low, leading to not so great nominal growth. The weakening link between the low unemployment rate and the trend in wage growth is puzzling economists and central bankers. This flattening of the so-called Philips curve is a widespread phenomenon, visible in the US, Japan and Europe. This also makes life difficult for central bankers. On one hand, they see the global economic recovery, better loan growth, export growth and high confidence indicators but on the other hand, given low inflation, there is no hurry for them to tighten monetary policy. Today central bankers have the luxury to be able to adopt a very gradual approach. For the ECB, policy is also complicated by the strength of the euro. Not because of its potential negative impact on growth, as we think the domestic economy is strong enough to cope with a stronger euro, but because of its downward impact on inflation expectations. In our view, the probability of a dovish surprise has gone up. For corporates, the low inflation environment is a mixed blessing. On the negative side, it limits top-line nominal growth. On the positive side it helps profit margins as wages are the biggest cost driver for most companies.
Earnings momentum has improved
This brings us to the second observation: corporate earnings growth. We make a distinction between the momentum in estimates and the actual growth expectations. It is remarkable that for the first time since 2011 earnings in both the US and the Eurozone increase at a double-digit pace. In addition, earnings momentum (the ratio of upgrades relative to downgrades) has improved over the past month and is currently positive for every single region, including emerging markets. For Eurozone earnings this may be somewhat surprising, given the strength of the euro, but it illustrates that the tailwind of higher growth is stronger than the currency headwind. However, this picture changes if we look at 2018 estimates. Next year, earnings for Eurozone companies are expected to grow less than global earnings and US earnings. This makes sense as currency movements are a slow burning issue where the Eurozone’s pain is the US’s gain.
Diverging political risks in Europe and the US
A third observation is the shift in perceived political risks. Remember that 2017 was supposed to become the year of all risks in the Eurozone with the elections in the Netherlands, France, and Germany on top of the Brexit discussions. On Brexit, we can be short. No progress has been made and the clock is ticking. Financial markets are not much bothered. UK equities trade primarily on international factors (GBP, commodity prices and emerging markets) and the Eurozone benefits from a strong domestic situation and is considered having the stronger hand in the negotiations. The election cycle went well thus far and in Germany Angela Merkel’s CDU will likely be the winner later this month. The main question seems to be who will be the main coalition partner: the FDP together with the Greens or the SPD in a grand coalition? This choice could, together with Macron, set the stage for a deepening of the Eurozone institutions. In the US, the trend is the other way round. From a Trump reflation trade to a powerless government that thus far has not accomplished much. On the contrary, we are facing a government shutdown (low impact on equities) and a debt ceiling (high potential impact) in mid-December now that Congress is set to approve a 3-part bill that includes Harvey emergency aid, a continuing resolution, and a debt ceiling increase through December 15. The odds may change in 2018 with the elections in Italy and the Trump administration beating the by now rock bottom expectations.
Valuations and behavioural dynamics are a mixed bag
Valuations are up for discussion. In an absolute sense, price/earnings ratios are high but not extreme. Relative to fixed income instruments, equities are in line with or more attractive than historic averages. This is especially the case for the Eurozone and Japan. The US equity risk premium is somewhat below average. What is sure is the fact that long-term return expectations have shifted down. This is not surprising given the year-long rally we witnessed and the impact of a lower nominal growth environment. For the US and the Eurozone, the expected long-term return is below 6% whereas in Japan it is above 6.5%. This is short of the past trend rate of return.
The behavioural side of the equation is mixed. The bull/bear indicator of US individual investors indicates some pessimism without being at contrarian levels. Our sentiment indicator however continues to give a negative signal. This signal is based on an analysis of news and social media articles. Also futures positioning is high and short-term price momentum is negative. The flow picture looks somewhat better. Of the past 12 weeks, we had 11 weeks of inflows. We nevertheless observe a shift in these flows away from the Eurozone towards the rest of the world, including the US.
So, we have a positive fundamental picture combined with short-term behavioural indicators that warrant some caution. But what about the risks? Risks are of geopolitical nature with the US-North Korea standoff. A further sharp drop in the US dollar is another risk and could be related to the failure to raise the debt-ceiling beyond yesterday’s three-month extension deal. Finally, a monetary policy error cannot be ruled out either and this would represent a serious shock to investors’ confidence.