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A New Equity Outlook for 2015

 

The essential

With global growth set to be above 3% and abundant liquidity likely to continue, the signs are positive for equities in the medium term.

It should be borne in mind, however, that the equity markets are undergoing transition and each market is at a different stage of the cycle. The US market may not experience any major new trends. The eurozone represents the most risk but also the greatest potential. In the middle, Japan offers a slightly lower risk-return profile. The emerging markets, meanwhile, should be assessed on a caseby- case basis.

We have identified four investment focuses:

  1. Positioning within the cycle: growth stocks (United States), reflation (eurozone), EPS momentum (Japan), commodity importers (emerging markets)
  2. Persistently low yields: yield strategies (dividend sustainability, real estate stocks, share buybacks)
  3. Monetary policy divergence between the United States on one side and Europe and Japan on the other side: domestic stocks in the US, international stocks in Europe and Japan
  4. The return of volatility: favour large-caps over small-caps

 

 

 

 

 

 

Equities were on a solid bull trend in the first half of 2014, but the positive momentum took a hit in early June when deflationary pressure returned to the eurozone. The eurozone’s equity market was the first to suffer; market interconnectivity then took care of the rest. The announcement of QE by the ECB led to a rise in the US dollar, which in turn pushed down commodity prices and the emerging markets in early September. By mid-September, concerns about global growth were dragging down the US market. The turmoil reached Japan’s shores at the end of September. By October the downturn had become more widespread.

This correction—which has already caused two down legs in Europe (see Chart 1)—may continue into early 2015 before taking a more constructive turn. Indeed, the readjustment of portfolio risks may not yet be fully over. Furthermore, it will take one or several more quarters before the low level of long-term yields, the low price of oil and the weakness of currencies in defl ation-prone countries (eurozone, Japan) produce their positive effects on the economy and on corporate profits.

Although the transition between the policies of the Fed and the other major central banks (led by the ECB and Bank of Japan) has not been without its complications, it will ensure a continued flow of global liquidity. And while global growth is expected to stay above 3%, the environment remains favourable to the equity asset class overall. In this transition phase, each market finds itself at a different stage of the cycle:

The United States, furthest ahead in the cycle, is now in a more mature phase (Phase iii of our roadmap)

In May 2013, Ben Bernanke’s remarks about Fed Tapering marked the transition from Phase i to Phase ii (see discussion paper titled «The Short Investment Cycle: Our Roadmap» and Chart 2). Before his remarks, the market had feared deflation and equities had followed a similar trajectory to inflation anticipations (see Chart). Then, with the market no longer fearing deflation, but neither concerned about inflation, the US equity market entered a sweet spot period: as long as inflation anticipations were low, equities rose.

Anticipations that the Fed’s QE measures would end marked the beginning of Phase iii. The decline in small-cap stocks, the inability of the high-yield segment to exceed its year-to-date peaks, the return of volatility (18-to-24-month lag with monetary policy) and the drop in commodity prices all support this view.

This phase of the investment cycle is more uncertain. The US market may not experience any major new trends and volatility may remain. The lower price of oil and the drop in long-term yields will help the economy stay the course for a gradual recovery above its potential, estimated at 1.9%. Corporate profit growth, while not accelerating, should at least hold up relatively well; moderate growth between 0% and 8% (2% of it due to the accretive impact of share buybacks) is foreseeable. The likely change of tone by the Fed should also have a reassuring effect. The drop in inflation anticipations is a step in this direction (see Chart 2); these are even approaching levels seen when the Fed launched its previous QE operations. This may suggest that the Fed could return to these policies if necessary. Communication efforts may also prove sufficient. However, a substantial improvement in the economic environment would raise the spectre of a rise in key rates, which may be judged inadequate by the markets.

At this stage, valuation also fails as a decisive predictor of the market in 12 to 18 months’ time. While valuations may seem a handicap for the long-term performance of US equities (Schiller P/E ratio at 26 times reported earnings and 23 times operating profits), the weak inflation backdrop justifies the current P/E ratios (16.7 times the last twelve months’ profits). According to Chart 4, inflation of around 2% is consistent on average with a P/E ratio of 18 times trailing earnings.

The eurozone (in Phase i) is also in a transition phase, albeit at an earlier stage

The MSCI EMU Index has undergone re-rating—P/E ratios rose from 8 to 14 since 2011, peaking in 2014 before falling lower again recently. To move forward, the market must now be driven by a recovery in profits, which is slow in coming. However, the transition between the two phases is being complicated by the weakness of economic growth (below its potential growth rate of only 1.2%) and by the renewed risk of a deflationary spiral (30% probability according to the IMF).

That being said, the weakness of the euro should end up adding approximately 10% to earnings growth according to our currency exchange scenario (EUR/USD at 1.20 in one year). The consensus view holds that profits will rise 15% in the 12 coming months. This figure may be a bit high, but it is not wholly unjustified, as positive revisions in response to the foreign exchange effect could offset news of sluggish domestic growth. The fact that the ECB has taken matters into its own hands is also a welcome development. Finally, stimulus measures such as the Juncker plan (€300 billion) are a positive sign. The risk in the eurozone is more a matter of how long it will take for these good intentions to turn into action.

If defl ationary risk sets in, valuation levels will certainly be downgraded, as will profits—a sort of double penalty. However, if these risks abate, the opposite will occur—a double bonus. The relationship that can be observed between P/E ratios and long-term US inflation is a reminder of this implacable mechanism (see Chart 4). Additionally, the eurozone, which is at Phase i of our representative road map, is certainly the part of the developed world that represents both the most risk and the greatest potential («high risk-high return»).

Japan (near Phase ii) may be seen as an alternative to the eurozone

Japan is also trying to escape deflation, but its measures were taken slightly earlier in the cycle; «Abenomics» took off before «Draghinomics». The 30% drop in the yen led to a 75% profit increase in 2013. This momentum has slowed but it remains positive (+6% in 2014 and +12% in 2015 according to the IBES consensus. It should benefit from the extension of accommodative policies by the Bank of Japan while economic growth is expected to soon exceed its potential, estimated at approximately 0.7%. Japan may well be near Phase ii of our roadmap. In the short term, Japan offers a lower risk-return profile than that of the eurozone.

The emerging markets (Phase iv) are under the influence of both China and the US dollar

Two factors—China’s slowdown, even if under control, coupled with a stronger US dollar—have the effect of pushing down the associated commodities, currencies and equity markets. This dual trend has been very rapid in recent weeks, and a springback is certainly possible. But China will maintain its policy of small steps to manage its slowdown, and monetary policy divergence between the United States and the rest of the world is likely to continue. Meanwhile, commodity-importing emerging markets in Asia are expected to outperform commodity-exporting Latin America.

From a regional perspective, the eurozone could end up back in the limelight in 2015. However, in our view, the best approach to the equity markets would be a cross-sectional one that does not focus on a single region.

We have identified four investment focuses for 2015:

  1. Positioning within the investment cycle: this calls for a more conservative approach to the United States with a focus on growth stocks, namely intechnology and healthcare. In Europe, the approach should be geared toward reflation (i.e. banks) and in Japan toward EPS momentum. In the emerging markets, the focus should remain on importers of commodities, especially in Asia, India in particular.
  2. Yields will remain low for some time: a number of different yield strategies should be considered. In the United States, the dividend sustainability and share buybacks call for attention. Meanwhile, attractive yield is one of the characteristics of European stocks in general. The listed real estate sector is also attracting interest in the developed economies.
  3. Monetary policy divergence, between the United States on one side and Europe and Japan on the other side, is likely to persist and the US dollar should continue to climb. This calls for prioritising domestic stocks in the United States and international stocks in Europe and Japan.
  4. Volatility will remain. Favour large-cap stocks over less liquid small-cap stocks.

 

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The US market may not
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Eric MIJOT, Strategy and Economic Research at Amundi
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A New Equity Outlook for 2015
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