Author: NN Investment Partners
Our 2018 outlook for equities is positive, thanks to a benign macroeconomic environment and double-digit global earnings growth. Returns will mainly have to come from earnings growth though, as the room for multiple expansion looks limited. Japan is our preferred equity market.
There are good reasons why absolute valuations are elevated and may stay so, but they are not likely to move meaningfully higher in 2018. Returns are capped by the earnings outlook.
Constructive view on equity markets in 2018
It is again that time of the year when banks and asset managers publish their outlook for 2018. NN IP follows this tradition and this week we present our equity outlook. Readers should keep in mind, though, that this is our base case which will face a world of macroeconomic, corporate, policy and political uncertainties and therefore will have to be adapted accordingly.
Overall, we have a constructive view on equity markets. Equities could once again become the best-performing asset class in 2018. This is primarily linked to the benign macroeconomic environment, which is characterized by robust growth in all regions and supported by all economic actors (consumers, corporates and governments). This means that the risk of a recession over the next 12 months is very low. Historically, only recessions have turned an equity bull market into a bear market.
Related to this favourable growth outlook, we think global earnings can continue their double-digit growth pace. Margins have room to expand, especially outside the US, as wage growth remains subpar and cyclical sectors’ earnings are recovering. Commodity and Technology earnings will play a crucial role in this margin recovery. There will be regional differences, whereby US earnings may get an additional boost from a reduction in the corporate tax rate. These are hardly accounted for by the market. Currencies will also play an important role in the outlook, whereby a weaker currency creates a competitive tailwind, which is especially important for an export-dependent economy like Japan.
Earnings growth likely the main driver of market returns
Of course, this positive environment comes at a price. The global equity risk premium has fallen below its long-term average, even if there are still attractive pockets in the Eurozone and Japan. Also when we look at absolute valuation metrics like price/earnings (PE) or the cyclically-adjusted PE we see that these metrics have risen to the highest post-crisis levels. Even if there are some good explanations why valuations are elevated and might stay so (upward trend in earnings, low cyclically-adjusted earnings in Financials, Materials, Energy, and abundant liquidity), it would be unwise to assume that these would move higher in 2018. If anything, current valuation risks are somewhat tilted to the downside. This also implies that the expected market performance will be capped by the earnings outlook.
The main factor that may weigh on valuations is monetary policy. Even if policy will remain easy and contain no surprises, we have come close to the point of maximum monetary support. The Fed will gradually step up the pace of its balance sheet reduction and the ECB will reduce its monthly asset purchases from EUR 60 billion to EUR 30 billion as from January. We do not expect changes from the Bank of Japan. In addition, the Fed will continue its path of gradual rate hikes. We currently expect two rate hikes in 2018, but must admit that this path is surrounded by uncertainty and the likelihood of three or even four rate hikes has increased. This is not priced currently and is a risk for especially fixed income markets, but potentially with negative spill-overs into the equity market.
Furthermore, politics and policy will continue to keep investors wary and may inject a dose of volatility into markets. For next year, we see three big challenges: The Italian elections in Q1, the US tax plan and the US mid-term elections in November. The US tax plan may have the biggest impact on investor sentiment. Currently not much is priced in earnings estimates so this may give markets a boost. The Trump administration really needs something to show the electorate with the mid-terms coming in November. With only a 2-seat Republican majority in the Senate, the process may drag on well into 2018. The Italian elections are even trickier if the recent Sicilian result is of any guide. The risk of a 5 Star Movement-led government looks limited, however. On its own, each factor has the potential to generate market volatility, but under the current benign Goldilocks scenario also looks unlikely to derail the market in a lasting way.
This is one of those elements that have changed for the better since the summer. Not only the fundamental drivers are positive, but also the behavioural market drivers have improved. This has made the market more resilient to event risk. Of course, as we saw earlier this month, this does not make the market totally immune to corrections resulting from e.g. position squaring.
We like Japan, emerging markets and the Eurozone
In this environment, our preferred regions are Japan, emerging markets and the Eurozone. In Japan, political and policy risk look the lowest now that Shinzo Abe has been re-elected Prime Minister. The equity risk premium is around 6%, almost double the US risk premium, and improved profitability comes at a discount relative to the Eurozone. An important driver of Japanese equity market performance is the evolution of the yen. This will remain so, although recently the currency-sensitivity of Japan abated somewhat.
We like emerging markets because of the positive domestic demand outlook, especially outside China, and easy financial conditions are underpinning credit growth. We expect China to go through a moderate slowdown, but see little tolerance by the authorities for growth falling below 6%. In the meantime the high leverage is being tackled. Furthermore, emerging markets are a beneficiary of the global trade recovery. IT has replaced the commodity sectors as the most important segment of the market. Finally, emerging markets trade at a substantial 20-25% discount to developed markets. Headwinds could come from a tightening of financial conditions following tighter US monetary policy or more hawkish Fed expectations, or from a stronger US dollar. In the short term, extended positioning could act as a drag as EM equities are a consensus overweight position.
Finally, we prefer the Eurozone to the US because of three reasons. Firstly, it is a more cyclical market than the US which in the current stage of the cycle should benefit the region more. Secondly, the market offers a higher equity risk premium, and thirdly, Eurozone monetary policy is more supportive than US policy and likely to remain so over the coming year. The biggest risks are centred around politics, with the Italian elections in Q1 and the impact of a strengthening euro on the earnings outlook.
We prefer cyclical sector exposure
In sectors we have a preference for cyclical exposure. This strategy is supported by three elements: strong macro data, higher bond yields following gradually tighter monetary policy, and stable to rising commodity prices. The energy and materials sectors obviously benefit from the latter, while financials is our preferred sector given its low valuation, good earnings outlook and positive correlation with bond yields. As we expect a moderate rise in bond yields, financials should outperform typical search-for-yield sectors like utilities and telecoms.