Americas CIO View

Since late summer, we warned of two main threats to risk assets this autumn: U.S.-China trade tension and rising interest rates. Up until last week, the U.S. equity market shrugged off the escalation of tariffs on China imports and harsh rhetoric making a deal less likely. The quick 6.7% selloff from Oct 3-11 acknowledges that this is not simply a trade conflict with regard to certain goods, but rather part of deeper issues and battles between the U.S. and China - intellectual property, next generation IT development, global economic influence, and maybe other economic and geopolitical fronts. Therefore we believe there is no easy and quick resolution and the trade conflict may get worse before it gets better.

The 40 basis points (bps) surge of the 10-year Treasury yield since late August caught the bond market off guard and spilled over to the equity market. But in our view the 10-year yield will likely stay between 3-3.25% until 2019 end on gradual U.S. Federal Reserve (Fed) hikes and tamed inflation. We don’t think it will rise significantly above 3.5% for the rest of this cycle. The same uncertainties remain – interest-rate volatility, global trade conflict, emerging-market instability, Italian fiscal policy, still unsettled Brexit - but we think this pullback offers a good entry point for better upside through 2019.

Since 1957, 5%+ S&P 500 dips happen twice a year on average, and 10%+ corrections happen once every 1.5 years. Of all the 5%+ dips, 40% of them turned into 10%+ corrections. The average selloff of all 5%+ dips since 1957 is 12.0%. But for those dips that didn’t turn into a full 10%+ correction, the average selloff is 7.1%. The current selloff is 6.9% (from Sep 20 peak to Oct 11 trough) and seven months since the Feb 8 trough of the last correction. Full corrections usually happen only with significant negative shocks or big shifts on S&P earnings-per-share (EPS) outlook or interest-rate moves. We think existing uncertainties in the market aren’t significant enough to trigger such scenarios. More companies should guide with higher tariff impact on their 2019 earnings and we see some cuts to 2019 consensus S&P EPS during the 3Q earnings season, but the cut is likely limited to 2-3% and we think S&P can still deliver ~6% EPS growth instead of the 10% expected now. We see a low risk of a near-term correction.

We see the risk-reward on S&P 500 more attractive now and therefore change our “Next 5%+ move” of S&P 500 from Down to Up. Our 2018 and 2019 yearend targets remain 2850 and 3050, which are 5% and 12% upside from the 2700-2750 levels. We believe the recent yield-curve steepening is fleeting. Yield curve should remain quite flat on weaker global growth outlook and no signs of inflation rising significantly above 2%. We think the 10-year Treasury yield will not trade significantly above 3.5% through 2019 yearend, mostly within a 3-3.25% range. This indicates the real 10-year yield stays below 1.5%, which is still supportive of an 18x price-to-earnings (PE) multiple (4% equity risk premium assumed) for S&P 500. Applying an 18x PE to our $161 and $171 S&P EPS estimate for 2018 & 2019 is 2900 and 3080.

Fot the S&P 500, we assign an overweight (OW) to the newly reclassified Communication Services sector, together with Tech, Health Care, Financials and Real Estate. Within the Communication Services sector we OW Entertainment and Interactive Media & Services, and EW Diversified Telecom and Media. We move Utilities from OW to equal-weight (EW) after its recent 10%+ outperformance vs. the S&P and with the 10-year yield likely staying above 3%. Real Estate is our preferred bond substitute play on its much lower-than-history valuation premium vs. the S&P and its inflation-hedging features. We continue to under-weight (UW) Energy, Materials, Industrials, Consumer Discretionary and Consumer Staples.