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Equity Portfolios - Top Down Views from Amundi Research

The markets do not price in the end of a cycle until a few months beforehand. As a US recession – and, hence, a global recession – is unlikely in 2018, the markets will probably continue to perform well. However risks are also increasing.

Have US equities become so expensive that they have hit a ceiling? No, but it shows that the risk-reward has deteriorated

Relative to interest rates, US equity valuations are not extreme. However, the lack of supply of bonds has pushed yields to abnormally low levels. So it is worth comparing equity valuations directly with inflation. This is where the “rule of 20” comes in. Each time that the P/E on trailing 12-month earnings moves above the “20-inflation” level, it is overvalued.
That is now the case, as it was in 1987 and 1996. In our view, this measure is a good indicator of market exuberance, keeping in mind that while there was a crash in 1987, in 1996 the market continued to rally for another three years.

Is volatility gone forever? No, it should rebound sometime in 2018

Volatility is a trailing function of monetary policy. It generally rises about two years after key rates begin moving up and the Fed began to raise its key rates in December 2015. This is due to liquidity. Adding liquidity reduces volatility, and vice versa. Although central banks are proceeding cautiously, the liquidity argument, which has carried the markets since 2009, is now reversing its momentum. This trend will gather strength in 2018.

Can earnings continue to drive the markets higher? We think so

The synchronisation of global growth is a favourable factor. In the United States, assuming, conservatively, that margins remain stable, earnings growth will be close to nominal GDP growth, i.e., ca. +4%. In addition, we can look forward to the tax cut, the accretive impact of share buybacks, and the delayed impact of the weak dollar. Thus, the Ibes consensus of 11% EPS growth seems credible. Elsewhere, margins are likely to improve. In the eurozone, they lag behind the US by 22 months this time. Higher bond yields, which help banks, are a key factor to this improvement. Nor are margins in Japan, which are at a high since the 1980s, showing any sign of weakness. And, lastly, the upturn in earnings in emerging markets is likely to extend into 2018.

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December 2017

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Against this backdrop, what is to be done on a regional level?

While the US market is expensive and the cycle is expected to last beyond 2018, the other markets are less expensive and now re-synchronised with the US and, as a result are more attractive. However, given these markets’ high sensitivity to the behaviour of the US market and how mature the cycle is, investors should consider only moderate risk exposure or to implement hedges.

1/ S&P500 Price Earnings Ratio (PER) and the “Rule of 20” 2/ Fed rates and US Equity Volatility
  • The eurozone: improved margins, re-steepening in the yield curve (good news for banks), renewed inflows (which, however, would mean an appreciation in the euro) are keys. Political risk (Catalonia) is less systemic in nature. Brexit, of course, is the elephant in the room but is expected to burden UK assets more than European ones.
  • Japan: further rise in margins, ongoing improvement of governance, and inflows (BoJ and pension plans) are constructive arguments. However, the yen, which is closely correlated to equities, will remain decisive. Shinzo Abe’s election success points to continuity in economic and monetary policy (weak yen). However a significant market shock, if one was to occur, would strengthen the Japanese currency and weight on equities.
  • Emerging markets are riding the synchronisation of global growth, which is also a boost for commodities. This moderately bullish scenario can be derailed by USD appreciation, Fed rate hike (if stronger than expected), Fed balance sheet normalization, global (and China) growth deceleration.

What are the themes for 2018?

There are four key themes at this stage of the economic recovery:

  • Upturn in inflation: overweight companies with pricing power (e.g., luxury goods companies). Financials may also benefit from the higher bond yields that are coming late in this cycle.
  • Upturn in investment? The resynchronisation of global growth and the upturn in earnings are arguments for this theme. However the decline in potential growth is cooling things off. The idea is that investors at least should keep some cyclical exposure and not switch too early to a purely defensive strategy.
  • Look for quality: Growth stocks are very expensive globally, a consideration that is feeding the theory of a bubble. Quality companies, which are less leveraged and less expensive, are clearly a good trade-off.
  • Watch out for liquidity: as regards equities, this theme concerns mainly small caps. True, their earnings remain strong for the time being in Europe and Japan. And in the US, the upcoming tax reform is a true argument for these more domestically oriented stocks. However these arguments will vanish during the year as liquidity will be less supportive.

What about Emerging markets?

  • The most appealing area for 2018 is EM Asia, mainly India, Indonesia and the Philippines. We see three reasons for this: 1) widespread quality, 2) convergence of positive macroeconomic environment (in terms of growth, inflation and liquidity), 3) low vulnerability vs other GEM and good fundamentals. After a strong rally in 2017, China looks expensive. Anyway the ongoing process of reforms can improve the market picture. FXs seem overvalued in many of the Asian countries which warrants hedging positions.
  • We also remain positive on EMEA (mainly Turkey and South Africa). Equity fundamentals are good and growth will remain supportive. South Africa is appealing (strong earnings and decent valuation). Growth is still weak but improving, with some weakness on the fiscal side. Turkey is inexpensive with high profitability and robust earnings growth. However, a cyclical slowdown in 2018 will call for more fiscal expansion and monetary accommodation, making more difficult for inflation to move towards the CB target. FX seems attractive on a 12-month horizon.
  • In LATAM we are more cautious: macroeconomic conditions improved during this year but the equity market rally made the area expensive, with the only exception of Mexico. The area could become attractive if some correction occurs.
3/ EM Scorecard
DELBÓ Debora , Senior Equity Strategist
MIJOT Eric , Head of Equity Strategy, Deputy Head of Strategy Research
WANE Ibra , Equity Strategy
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Equity Portfolios - Top Down Views from Amundi Research
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