Jun 17, 2019 Equities

More troubles ahead

  • The combination of the year-to-date rally and deteriorating prospects of a trade deal make the near-term risk-reward for equities unattractive.
  • In the near term, the U.S. budgetary process as well as trade could add further volatility.
  • Over the next 12 months, we expect companies and investors to adjust to the new global political environment, allowing markets to trade higher.
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by Thomas Schüßler, Co-Head of Equities and Andre Köttner, Co-Head of Equities

Big gains so far this year and continuing trade conflicts limit the near-time upside in equity markets.

After a few turbulent weeks, it is easy to forget just how well global equities have performed since the start of this year. Until early May, some indices had already surpassed our strategic target levels for March 2020. To understand the current situation, it is helpful to recall how we got here. Since the start of 2019, a supportive U.S. Federal Reserve (Fed), solid economic growth in the U.S. and China, reasonable company earnings reports in the first quarter and the hope of a U.S.-Chinese trade deal helped risky assets to make up all of the ground lost in the fourth quarter of 2018.

In recent weeks, however, markets have reassessed two parameters – trade and interest rates. In our view, the U.S.-Chinese trade conflict is unlikely to be resolved through a "big deal" in the near term. Instead, higher tariffs and new non-tariff measures appear to stay longer than we had originally hoped for as the conflict moves from its economic to its geo-political dimension.

The U.S. appears increasingly keen to try to shape and align the rise of China with U.S. interests. This is evident from restrictions on leading-edge U.S. technology exports and limits on Chinese exports. We have not heard of many changes to the global supply chain yet, as these take longer to implement. However, several companies are already reporting that they are delaying investment decisions and expecting a negative impact on global consumer spending.

The combination of the year-to-date rally, deteriorating prospects of a trade deal and potential near-term volatility in the U.S. budgetary process make the near-term risk-reward for equities unattractive, in our view. We now consider the risk of a full-blown correction (with the S&P declining by more than 10% from its peak) as high.

The difficult environment in certain cyclical sectors such as cars, semi-conductors and industrial goods excluding defense is likely to persist. As a result, the previously expected earnings recovery in the second half of 2019 remains at risk. The trade conflict is evolving, as the recent, very worrying signs of an escalation with Mexico show.

Increasingly, trade tariffs are becoming an all-purpose weapon, serving as instruments not only to promote fair trade, but other policy priorities of the Trump administration as well. In the case of the recent Mexican tariff threats, the stated objective was to strengthen U.S. border security. As of June 10, the punitive tariffs were not enacted after Mexico agreed to a range of measures that seek to reduce illegal immigration. Still, these threats have introduced a new quality to various trade disputes.

To put it bluntly, erratic trade measures announced via Twitter do more than just hurt U.S. relations with allies, such as Mexico, and geopolitical rivals, such as China, alike. Nor do they just damage sentiment in financial markets – an effect partially ameliorated by financial-market expectations that the Fed might come to the rescue by cutting rates.

More fundamentally, tariffs, like any government intervention in free markets, create distortions. They effectively act as a tax on U.S. consumers and often do so in capricious, unpredictable ways. Washington bureaucrats are in charge of how and to which specific goods tariffs and other trade measures are applied. Worst of all from the perspective of U.S. companies and their shareholders, companies are often penalized for investment decisions that cannot quickly or easily be reversed.

As a first approximation, we think that the tariffs implemented so far will have a 3% negative impact on U.S. earnings per share this year, as a direct result of higher import costs. However, this is very much a "place-holder" estimate. It does not, for example, reflect the reduced value of U.S.-owned plants abroad, if protectionist policies are sustained. Conversely, there could of course be some upside because of reduced foreign competition, again at the expense of U.S. consumers and longer-term growth prospects. Eventually, investors would have to totally reevaluate the risks posed to individual companies and industries. The use of non-tariff measures, such as black-listing individual companies, is especially worrying in our view.

Of course, there remains some hope that policymakers will change course, before all of these potential costs fully materialize. For now, we keep the base-case view that a global earnings recession will be avoided. Defensive sectors, secular-growth segments, such as software, digital payments and health care, as well as share buybacks should help to support some moderate growth in earnings per share in the U.S., Europe and emerging markets.

The second parameter that requires a review are long-term interest rates and their impact on valuation multiples. Modest global-growth prospects and limited inflation are likely to leave the U.S. 10-year yield "lower for longer"; this is reflected in our updated CIO View forecast which predicts unchanged U.S. 10-year yields of 2.30% on a 12-month horizon. We remain of the view that low yields are not harbingers of an economic recession in 2019 or 2020. Instead low interest rates should allow equities to sustain structurally elevated valuation levels at or above historical averages.

That again presupposes that trade tensions do not get out of hand completely. In the near term, the U.S. budgetary process as well as trade could add further volatility. On this, the political calendar could prove modestly helpful. With the U.S. elections of 2020 already looming large, both Congress and the Trump administration may have strong political incentives to try to prevent further escalations.

While we see near-term downside risk for equity markets we expect companies and investors to adjust their expectations to the new global political environment over the next 12 months. In our view, the S&P 500 could reach levels of 3000 by June 2020, implying an unchanged price-earnings ratio of 17.3x. In the rest of the world, we forecast a widening valuation discount to the U.S. as our confidence in a cyclical earnings recovery is fading. For the Dax we see little upside, as the automotive industry faces continued demand weakness.

Obviously, the trade conflict has made it difficult for our emerging-markets overweight to work. We are keeping the highest 12-month return forecasts due to attractive valuation and strong expected 2020 earnings-per-share growth. In the near term, however, we no longer prefer the region to others.

Not yet cheap
Despite recent market turbulences, most major equity markets remain more expensive than recent historic averages. Fears of a global slowdown could prompt further corrections.

Sources: Thomson Reuters Datastream, DWS Investment GmbH as of 6/10/19

 

Valuations overview

U.S. equities: Neutral (Neutral)*

The short-term outlook for U.S. equities appears decidedly murky, not least given trade and geopolitical concerns. Trade could easily knock a few additional bucks out of earnings estimates, if tensions escalate further or the economy continues to weaken. It might also take a while yet for the U.S. Federal Reserve (Fed) to come to the rescue. That said, we would expect companies and investors to be able to adjust over the next 12 month, suggesting some upside sooner or later as we head into 2020.

Sources: FactSet Research Systems Inc., DWS Investment GmbH; as of 6/12/19

* Our assessment is relative to the MSCI AC World Index, the last quarter's view is shown in parentheses.



European equities: Neutral (Neutral)*

In addition to trade, European investors face plenty of home-made issues. Politics could continue to generate unnerving headlines, about Brexit, Italy or the uncertain survival prospects of Germany's coalition government. More importantly, Europe's export-driven economies have already shown signs of slowing. This is doubly painful for equity indices, such as Germany's Dax, that are heavily exposed to such cyclical sectors as cars, semi-conductors and industrial goods.

Sources: FactSet Research Systems Inc., DWS Investment GmbH; as of 6/12/19

* Our assessment is relative to the MSCI AC World Index, the last quarter's view is shown in parentheses.



Japanese equities: Neutral (Neutral)*

In Japan, valuations continue to look compelling by historic standards. Then again, they have been so for quite a while. Corporate governance has been improving but the Japanese market is still lacking credible triggers for a rerating. Like Europe, Japan looks exposed to trade tensions. Recent earnings have been disappointing, especially among manufacturers and global cyclicals. Domestically, demand has been strong, but a consumption-tax hike scheduled for October could hurt sentiment.

Sources: FactSet Research Systems Inc., DWS Investment GmbH; as of 6/12/19

* Our assessment is relative to the MSCI AC World Index, the last quarter's view is shown in parentheses.



Emerging-market equities: Neutral (Overweight)*

In the short term, emerging-market performance looks set to be driven by changing expectations for U.S. interest rates, hopes for a trade deal between the United States and China, and tentative signs of stabilization in China. Given the potential risks in all three areas, we reduced our rating to neutral in May. That said, valuations continue to look attractive and we expect strong earnings growth, heading into next year.

Sources: FactSet Research Systems Inc., DWS Investment GmbH; as of 6/12/19

* Our assessment is relative to the MSCI AC World Index, the last quarter's view is shown in parentheses.

Performance in the past 12-month periods (in %)

05/14 - 05/1505/15 - 05/1605/16 - 05/1705/17 - 05/1805/18 - 05/19
Dax 14.8% -10.1% 22.9% -0.1% -7.0%
Euro Stoxx 50 10.1% -14.2% 16.0% -4.2% -3.7%
MSCI AC World Index 3.1% -7.4% 15.2% 9.7% -3.3%
MSCI Emerging Market Index -2.3% -19.6% 24.5% 11.5% -10.9%
MSCI Japan Index 39.2% -19.4% 12.5% 10.5% -11.8%
S&P 500 9.6% -0.5% 15.0% 12.2% 1.7%
Stoxx Europe 600 16.2% -13.1% 12.2% -1.8% -3.7%
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 5/31/2019

Past performance is not indicative of future returns. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect. DWS Investment GmbH as of 5/31/19.

This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. Past performance is not indicative of future returns. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.

DWS Investment GmbH as of 6/11/2019
CRC 068390 (06/2019); CRC 068453 (06/2019)

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