Year-end turbulence

Equities

Year-end turbulence

Plummeting equity prices and elevated volatility reflect many anxieties. We share some concerns but remain confident for 2019.

The job of equity strategists does not get any easier when equity markets correct – pull back at least 10% from their last high – or even enter a bear market with a 20% drop in the fourth quarter, just when the final touches are being put to the forecasts for the coming year. Nor does the situation improve when markets subsequently become either euphoric or panicky over trifles. The final straw is when major decisions are also expected around the turn of the year. Italy, Brexit and the (merely postponed) U.S.-Chinese trade dispute can trigger bouts of market weakness that initially militate against an optimistic outlook. Such turmoil can also make our forecasts look like it may be an opportune time to consider investing. This, however, is not necessarily the case. While our forecasts indicate where we see the indices trading at the end of 2019, they say nothing about the correct timing of investments over those 12 months.

Investors should not overestimate their ability to time the market anyway. But they should not underestimate either that major market moves create a powerful narrative of their own. Above all, the last two months have demonstrated yet again just how quickly price movements on the world's major exchanges can change the collective view of the economy and capital markets. Since market corrections can often be purely technical in nature, the key is not to jettison convictions from one week to the next. The resolve required has been demonstrated lately by the S&P 500's multi-day gyrations since the beginning of October: three times the index moved sharply lower (-11.4%, -6.5% and -11.1%) and twice higher (8.1% and 6.5%, as of December 20). A striking comparison is that all throughout 2017, as a whole the maximum potential loss (based on closing prices) never exceeded 3% – even based on the worst possible timing. But we think these days of excessive calm are over. Volatility at these higher levels will probably persist in 2019.

In the final analysis, there are still good reasons to expect more market turmoil before the situation improves. In 2019, we expect global GDP growth to slow only slightly, from 3.7% to 3.6%. Moreover, based on the current data, we see little reason to fear a cyclically driven recession in the United States in 2020. Our baseline scenario calls for global equities to generate single-digit returns next year, driven by moderate earnings growth and respectable dividends – the latter backed by strong corporate cash flows for most sectors. We have set our December 2019 target for the S&P 500 at 2,850, for the Dax at 11,800, and for the Stoxx Europe 600 at 360 points.

Our basically bullish scenario could, however, be negatively impacted by a number of policy decisions. The recent market corrections and elevated volatility levels show just how concerned investors are about monetary policy in this late phase of the cycle – having previously, for several years, shrugged off any policy shifts. Our baseline scenario for the equity markets assumes they withstand a raft of policy decisions. We also assume the U.S. trade dispute will not escalate into a full-blown trade war. We expect the Fed not to tighten on auto pilot but to factor in deteriorating macro conditions, and also not to ignore the impact its actions have on equity markets and emerging markets (EM) in particular. We also assume that the Italian budget policy will not challenge the integrity of the Eurozone and that Chinese efforts to boost domestic consumption will prove successful, and permit a controlled slowing of the Chinese economy.

We no longer consider equity valuations to be rich. Valuations based on earnings or free-cash-flowmultiples are at or below recent historical averages. The key question for equity investors is the sustainability of the current high level of profitability. We assume it to will remain high at least through 2019, but consensus estimates for most markets still have to be corrected downwards. In our view, they do not adequately reflect lower GDP growth, higher wages and new trade barriers. Overall, operating margins in developed markets will probably not rise further, so we think 5% to 6% earnings growth is an appropriately cautious assumption. We expect higher growth for emerging-market equities. Given the major uncertainty about near-term policy decisions, we are refraining from taking strong tactical positions – be it at a regional or sector level. Since the structural rise in the emerging markets looks set to continue in coming years, we are waiting for the right opportunity to overweight the region again. But for that to happen, the U.S.-Chinese trade dispute, the U.S. dollar and global interest rates must be heading in the right direction. We also assume that the digital revolution affecting virtually every sector will continue. Differentiating between the winners and losers of this technological shift remains a central investment issue for growth strategies. For the time being, however, even the heavyweights and former sector favorites must come to terms with falling instead of steadily rising consensus estimates. Here too we are waiting for better buy-in levels.

First blemishes in the very bullish forecasts

Consensus still expects another two fat years for S&P 500 earnings. The estimates* have, however, fallen slightly since late summer.

Valuations

Valuations overview

U.S. equities: Neutral (Neutral)*

Growth and valuation concerns have hurt U.S. equities. We feel sentiment has deteriorated too much. As we expect no recession, mid-single-digit earnings-per-share (EPS) growth in 2019 and 10-year Treasury yields no higher than 3.5%, we believe the correction offers some opportunities. There could be downward pressure though as earnings forecasts are starting to fall and Treasury yields offer an attractive risk-adjusted alternative.

European equities: Neutral (Neutral)*

Political and macro uncertainties make it necessary to monitor how events in Europe evolve. Issues such as Italy, Brexit and trade tensions are weighing on markets. Therefore, we remain neutral and wait for a better re-entry point. In general, corporate fundamentals remain solid, and the recent drop in markets has made valuations look increasingly attractive, with the discount to U.S. price-to-earnings (P/E) ratios at 10-year highs.

Japanese equities: Neutral (Neutral)*

We believe strong balance sheets and solid earnings of corporate Japan remain fundamentally attractive. However, the signs of a slowdown in the earnings-recovery cycle leave us on the sidelines. Corporations have surprised by not yet revising up their conservative earnings forecasts. Furthermore, Japan may not necessarily be a place to hide if one expects a late-cycle slowdown.

Emerging-market equities: Neutral (Neutral)*

Emerging markets (EM) will be an interesting asset class in 2019. While there are risks that a stronger U.S. dollar (USD), higher U.S. rates or a trade-war escalation will weigh on EM equities, this is not our base case. On average, EM companies have strong balance sheets and they are trading at compelling valuations. We believe, however, that earnings forecasts still need to come down, depending also very much on Chinese growth.

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