More muted equity return outlook with higher volatility

Investment strategy - 1/23/2018

In short
  • From here, a continuation of benign macro conditions is crucial for further equity price appreciation
  • Sticking with our preference for European shares
  • Rotation away from technology and growth shares likely but this may not be enduring

While we expect the favourable backdrop of widespread economic growth and contained inflation to be present as we head into 2018, we question just how long this ‘Goldilocks’ scenario can endure.

Investors should not underestimate the significance of this since either a growth relapse or a bout of inflation could easily upset equities currently priced for near perfect conditions. In the absence of either of the above scenarios, we would anticipate any equity upset in the coming months caused perhaps by political, geopolitical or other exogenous events to be relatively short-lived. That said, given the extent of profits that investors may have accumulated as well as extended valuations, volatility is almost inevitably going to rise as we move further through the current cycle.

For now, though we can live with rich equity valuations, believing that in the absence of a meaningful deterioration in credit conditions, and in conjunction with such low corporate bond yields, valuations by themselves need not be problematic. However, with interest rates likely  to  increase  in the months ahead, we are not expecting multiple expansion to be the main driver of equity prices.

"Investors still have considerable firepower left to push prices up."
Richard Beggs - Global Head of Investment Strategy Private Banks Investments & Advisory at Edmond de Rothschild

Rather, we think it will be ongoing earnings growth and still plentiful global liquidity that continue to support prices. We note some measures of investor sentiment point to excess optimism, but we see leverage under control and believe that investors still   have   considerable   firepower   left   to   push prices up. On the earnings front, we acknowledge the challenge ahead for companies  to  maintain the strong growth they registered throughout 2017. Nonetheless, prevailing conditions are still supportive for solid profit expansion with wage inflation still under control and strong GDP growth underpinning sales momentum. Moreover, for the most part expectations are not excessive.

We expect sector rotation in the early part of the year

Technology shares stood out in the performance derby of 2017. This was true in all regions but most obviously in the US and Asia with a band of names including Activision (gaming software), Nvidia, Applied materials and Tencent leading the way. Beyond the pure technology plays and the social media giants that have also been the darlings of the market, it is obvious that investors ‘paid up’ for growth in 2017 with the performance differential between ‘growth’ and ‘value’ equities pronounced across most regions. This trend was by no means just confined to technology growth shares. By way of example, the S&P500 Internet and Direct Marketing Retail index rose over 45% last year and the S&P 500 Hypermarkets & Supercenters over 30%, but it’s worth noting that both industries have P/E multiples near 15-year highs. In contrast, companies lacking tangible growth, even if technically cheap,  were not popular. Defensive holdings including telecom and consumer staples companies as well as energy stocks were amongst those that languished.

For a few reasons, we would not be surprised to see investors take profits in their growth holdings. The first reason is that share price momentum (which most of the growth names currently possess) as a factor driving markets typically wanes in January. The second is that we think investors will view 2018 as they year in which the central bank ‘punch bowl’ is truly removed and that economic growth finally becomes self-sustaining with normalising inflation. As such, they will deem it unnecessary to pay high valuations for companies demonstrating steady secular growth and prefer the operating leverage of more cyclical companies either geared to a rise in corporate capex, a commodity price like oil, or just to a rise in top line sales. Combined with often appreciably cheaper valuations and having been shunned by investors for several quarters, the sudden switch in sentiment can have a dramatic effect on portfolio performance.

European shares have the chance to shine brighter

European shares badly lagged US counterparts last year. Their relative value was either not recognised or overwhelmed by other dynamics. Now, along with shares in Japan and much of Asia, European shares are still cheaper than those in the US. However, any multiple re-rating will require European companies to prove that they can capitalise on strong regional growth and push margins back to old highs.

"Any rotation from a ‘growth’ to ‘value’ style would likely support European outperformance."

One aspect that may have been less appreciated by investors is the significant sectoral differences between the US and Europe. The absence of a meaningful weight in technology (5%  vs  25%  in the US) has certainly been a drag on Europe given the technology sector performance in 2017. What may be more relevant for 2018 is the heavy relative exposure that Europe has in financials (22% vs 17% in the US). If we are correct in our assessment that sovereign yields rise globally and the economic strength in Europe persists, then  the  backdrop for financials would appear favourable. Finally, any rotation from a ‘growth’ to ‘value’ style which might be triggered by a resurgent capex cycle and, or, ongoing economic momentum (possibly with higher than expected inflation) would likely support European outperformance given the relatively high industrial weight within European bourses.

What could threaten the equity cycle?

In the coming months we see corporate disappointment as the main risk for equities. This could be in the form of deteriorating earnings growth relative to expectations, reckless re- leveraging or poorly perceived corporate activity. 2018 may be the year in  which  CEOs  abandon the more cautious ‘dividend hike and share buy- back routine’ and actually start investing in out- of-date plant, machinery, software and, of course, acquisitions. We already see a pick-up in the ‘animal spirits’ of industry leaders and if some degree of political stability can be achieved then this ‘window’ might remain open for a while. While we think this would be a positive development for sentiment, such business investment may not be immediately earnings enhancing even if it is desirable for longer term economic health.

A second risk is that of a policy mistake by central banks, or, for that matter, governments. Investors have considerable faith that the process of unwinding monetary stimulus measures can be orderly and without slip. Given the almost universal acknowledgement that equity and credit markets have benefited so much from such balance sheet expansion, it is quite bold to predict that the reversal of such expansion will not be detrimental to liquidity. It should also be noted that any upside surprise in inflation might lead to monetary policy in the US normalising faster than expected and thereby causing global financial conditions to tighten more than anticipated.

An additional factor we think investors need to watch is that of ‘change’. Change and disruption were major influences on industries in 2017 even if the changes started some time ago. The Internet, for example, has been widely used for almost two decades, but it was last year that hundreds of bricks and mortar retailers closed and other giants like Macy’s and Sears had to shrink to survive as competition from internet and off-price retailers took its toll. In another clear example, even though batteries have been around since the 1800s, improvements in energy storage are making solar and wind energy generation viable alternatives to gas and coal-powered electric plants. Aside from producing opportunities for battery companies, change has also reduced the need to build new electric plants (so impacting utilities and commodity producers) and directly impacted demand for the giant generators produced by GE and Siemens. Batteries may also be on the verge of driving major changes across transportation industries.

Blockchain1, artificial intelligence, and genetic engineering are also new developments that we think will contribute to the ‘shake up’ of the status quo. This will accelerate the obsolescence of entire business models for a number of industries with the commensurate effect on companies and their securities. All of this supports the case for an active approach to security selection and portfolio management in 2018 and beyond.

Richard Beggs
Global Head of Investment Strategy Private Banks Investments & Advisory
Edmond de Rothschild


1 The blockchain is an information storage and transmission technology, transparent, secure, and functioning without a central control organ.

The information about the companies cannot be assimilated to an opinion of Edmond de Rothschild on the expected evolution of the securities and on the foreseeable evolution of the price of the financial instruments they issue. This information cannot be interpreted as a recommendation to buy or sell such securities.




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