Constructive but vigilant

Equities

Constructive but vigilant

The global upturn is likely to continue to drive corporate earnings in 2018. Equities still have room, but risks are growing.

"Global synchronized expansion." Those were the words we heard the most at an investor conference in the United States at the beginning of November. Some 250 industrial firms were making their case. The atmosphere was so good that it could easily make you nervous. This aptly sums up the starting point for our 2018 stock-market outlook. Businesses are confident, order books are full, and orders are coming in from all over the world. Developed as well as emerging markets are surprising with positive economic data. Seldom in recent history have there been so few countries in recession as this year. According to consensus estimates, 2017 corporate earnings in the United States, Europe, the emerging markets, Japan and China are likely to grow in lockstep, with rates in the double digits. It would be the first time in ten years that we see such synchronized earnings growth.

These figures are only outstripped by various sentiment indicators. Sentiment among consumers in Europe and the United States is better than it has been for 17 years. According to the ifo Institute, German company leaders' assessment of the current situation has not been as positive since the country's reunification in 1990. Sentiment among U.S. purchasing managers was only significantly better in the mid-1980s. And what do investors make of it all? The data is somewhat confusing. There is no evidence of negative sentiment in any survey. The estimates range from 'average' to 'as high as last seen in 1985' (U.S. Advisors' Sentiment Report), but positive sentiment definitely prevails. The liquidity ratios^[1] of (global) institutional funds are only just below their ten-year average, but they have fallen markedly within a year. Fund managers are taking on above-average risks at the moment, for the first time since 2000.^[1] Meanwhile, the equity ratio in international hedge funds has reached its highest level in eleven years.^[1] The cash ratio in traditional European equity funds is 1.3% at present.^[2] This is more than twice as much as at the 2007 trough but still significantly below the ten-year average of about two percent. And yet, professional investors claim that they are not underestimating the risks for 2018. In short: There are often huge gaps between what fund managers say and what their portfolio looks like. What do the sentiment indicators, share prices and valuations tell us here? Compared to historic values, it can hardly be said that investors are lacking confidence at present.

Admittedly, it is very easy to find a fly in the ointment when it comes to sentiment indicators. With various sentiment indicators among investors, companies or consumers all open to interpretation, it is anybody's guess whether stock markets have already gotten ahead of reality. Not all signs in capital markets are pointing to euphoria either. Flat yield curves suggest some skepticism towards growth. This takes us to the issue of interest rates. Their importance may grow in the coming quarters, for example when it comes to the leverage ratio, which has reached record levels in U.S. non-financial companies again - both, in absolute terms and relative to GDP. In some sectors of the S&P 500, the net leverage ratio is significantly higher than in 2007. When looking at the interest coverage ratio, i.e. the ability to pay interest on outstanding debt from operating income, the situation is less worrying. However, concerns will grow once real interest rates start to rise. For quite some time, companies with weak balance sheets have been penalized in stock markets.

Some oxygen left

Despite some deterioration in corporate balance sheets, we are generally optimistic for 2018. This is primarily based on the sound economic situation. We expect global economic growth to accelerate to 3.8% in 2018. Added to this, we expect interest rates and volatility to remain low, but valuations to stay above the historical average. In this environment, a further expansion in valuation multiples appears unlikely. Instead, we expect slightly decreasing P/E ratios. The fact that we still expect total returns to reach high single digits in almost all markets is based mainly on two considerations: first, increasing corporate earnings - we expect, on average, high-single-digit growth rates in developed markets and rates of 15% in emerging markets; and, second, a dividend yield of about 2% (United States, Japan) to about 4% (Europe).

On a sector level, our approach remains procyclical. We continue to expect the main impetus to come from the technology sector again in 2018. Tech companies have already presented impressive figures this year. Even some enterprises with a double-digit billion-dollar turnover have seen increases by more than 50%. The drivers of this strong demand for technology are likely to persist in 2018. However, the good performance this year might make this sector particularly vulnerable to market downturns next year. The financial sector could become the second strong driver. The United States offers looser regulation, higher interest rates and rising distributions. In Europe, consolidation is advancing and restructuring efforts are likely to start paying off.

Although we are generally optimistic, we do not expect similar returns and similarly low volatility in the stock markets as in 2017. Just looking at the length of the rally might make many investors nervous. On December 13, the S&P 500 could beat its record of 532 days without a setback of at least five percent. This run could be stopped by surprising inflation figures, disappointing growth rates from China or the collapse of the U.S. tax-reform plans. After the current phase of high risk appetite, investors could abruptly unwind risk positions in 2018. Based on our overall benign economic outlook, we would see setbacks as an entry opportunity, however.

Company/sector contribution to S&P 500 performance

The S&P 500 has been more clearly influenced by the top ten (irrespective of sector) before, but technology has never been more dominant than in 2017.

Valuations

Valuations overview

U.S. equities

For the S&P 500, we still expect earnings-per-share (EPS) growth of 11% this year and 7% next year. Against this backdrop, the scope for further share-price gains looks limited. A major impetus from the planned tax reform appears increasingly unlikely. Not much is to be expected from the Trump administration in terms of infrastructure spending either. Our 2018 year-end price target for the index is 2,650 points.

European equities

Europe's economies are performing surprisingly well. Based on third-quarter figures, the Eurozone is set to achieve its highest growth rate since 2007. And, while sentiment indicators are already at multi-year highs, earnings expectations have barely risen recently. Overall, we remain optimistic for the Eurozone. We have lowered our tactical view for Germany to neutral but see potential for the Dax of up to 14,100 points by the end of 2018.

Japanese equities

The Japanese market has recently performed positively but is lagging behind Europe and the United States for the year as a whole. Abe's re-election has enhanced confidence in loose monetary policies staying in place. Meanwhile, corporate governance continues to improve. Corporate earnings in the third quarter grew by one-fifth, and earnings revisions are among the highest in developed markets. Japanese equities remain one of our favorites.

Emerging-market equities

The economic environment in emerging markets remains robust. It is especially appealing in Asia, where we continue to see both solid growth and low inflation. Neither the recovery of the dollar nor U.S. interest-rate hikes have prevented the region from performing better than the MSCI World. Unless the situation in North Korea escalates, we expect a similar result for 2018 – but across a wider range of sectors than in the year to date.