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October Investment Strategy - Who is afraid of equity valuations?

October Investment Strategy - Who is afraid of equity valuations?

Insight
24 October 2017

Key points:

  • As the European Central Bank is about to reduce the pace of its asset purchasing, central banks may globally succeed in their goal of removing their accommodative policies with a limited market impact.
  • US equity markets have reached new highs and raise questions. We find that current elevated valuations reflect both strong corporate fundamentals and very low interest rates, two supports unlikely to change in the coming year.
  • We maintain our positive bias towards growth-sensitive assets and add long US dollar positions.

Central banks on vacation? Not quite yet

The global financial crisis defied the vast majority of policymakers, but none more so than central banks. Based on economic history, and fearful of an economic depression like the one seen in the 1930s, central banks reacted vigorously and with unprecedented creativity. This led to exuberant optimism, which lifted equity markets like a high tide. It is now commonly accepted that quantitative easing (QE) and its various derivatives have lifted equity markets to unprecedented levels worldwide, while depressing interest rates. Conversely, markets now fear the tightening effects of the progressive removal of this ultra-accommodative monetary policy. In this month’s investment strategy, which is published at the same time as the appearance of the first signs that the European Central Bank (ECB) will begin to reverse its ever-expanding policy of monetary loosening, while the US Federal Reserve (Fed) has started unwinding its balance sheet, and as the Bank of England (BoE) looks set to hike rates, we focus on equity markets, with the aim of assessing the level of valuations.

Since the ECB Forum on Central Banking was held in Sintra Portugal in June, central bankers have prepared markets for a change in their respective policy stances, albeit very gradually: the speed of purchases, globally, is slowing. The Fed is largely expected to hike interest rates in December, and has given plenty of details on its planned balance sheet unwinding, leaving little uncertainty as to its actions, if not its impact. The Fed is beginning its quantitative tightening with $10bn of US Treasuries and mortgage backed securities (MBS) redemptions set to roll off its balance sheet during the fourth quarter of 2017. This balance sheet unwinding will really take off in 2018. The Bank of Japan (BoJ) is also slowing purchases somewhat.

More importantly at this stage, the upbeat economic momentum in the euro zone (even more so than expected) together with the euro stabilisation and careful communication on the part of the ECB have led markets to expect the bank to announce another reduction in the monthly pace of asset purchases at its October meeting. While several parametric options have been discussed, market and media consensus point to another nine months at €30bn, from January to September 2018, though leaving enough options open for markets to still feel the invisible hand of the ECB hanging over any undesirable market movements (whatever the source). More precisely, we expect the ECB technical adjustment to maintain the open-ended nature of the current QE programme ("and beyond if necessary"); its easing bias ("the Governing Council stands ready to increase the programme in terms of size and/or duration") and the sequencing with stable interest rates "well past the horizon" of the asset purchase programme – i.e. until 2019. To emphasise the Bank’s credibility and its willingness to keep its QE open-ended, the ECB is likely to mitigate the discussion on bond scarcity by providing more information on the composition of its balance sheet, possibly some granularity on the maturity and composition of national debt holdings with a view to providing enough information that markets not only downplay this issue, but also dwell on the possibility of duration effects (though in our view, preserving some slope on the yield curve is of the essence to support banks business model).

Altogether, this reduced QE flow from January onwards will continue to increase the stock of ECB public debt holdings (even as a share of outstanding debt) and add to the net negative supply for Bunds in 2018. We therefore expect a muted impact on Bund yields (with 10Y rising to 0.6% by year-end) while peripheral spreads should only widen a little (with net supply of Italian BTPs1 turning from negative in 2017 to slightly positive in 2018). Central banks are unlikely to take a vacation yet.

Still good for equity valuations and growth sensitive assets

It has long been a fear that the withdrawal of QE and a reduction in the level of purchases by central banks would create jitters on the markets, with uncontrollable jumps in interest rates and depressed equity valuations the results. Yet, it rather looks like ultra-cautious central banks may succeed in their goal of removing their accommodative policies with a limited and softer-than-expected market impact.

First, European equities do not appear overvalued or limited in their growth potential given the upbeat economic outlook. Over the past eighteen months or so, and in spite of a tumultuous and ongoing political cycle, European growth has kept on surprising: all indicators suggest that the upward phase of the cycle has further to go and activity could even accelerate, assuming the absence of political disruption. European equities have room to increase and prices may not yet fully integrate growth and inflation prospects, especially if the euro appreciates only slowly from here.

Second, even though US equities have reached new highs (in particular, standard metrics such as the Shiller P/E look extreme), they are supported by strong corporate fundamentals, irrespective of the forthcoming and yet-to-be-defined tax reform, and very low interest rates, which underpin both cheap debt financing and low discount rates. We see little reason to expect these supports to change over the coming year and little reason as well for a sharp correction in bond markets. Against that backdrop, valuation metrics look likely to self-correct over the coming two years as earnings grow. We calculate that, should US companies deliver on current earnings expectations in 2018 and 2019, current price levels would be consistent with a Shiller P/E of 25 (vs. 31 currently). Therefore, we anticipate modest single-digit total returns for US equities in 2018 reflecting moderate earnings growth, and some slowdown thereafter. An obvious upside risk is the upcoming corporate tax reform which could boost not only profits but also buy-backs if cash is repatriated from abroad – which we do not expect. In light of the forthcoming slowdown (2019) and because the key downside risk is domestic growth as current equity prices are particularly reliant on earnings delivery, we do not recommend getting longer in US equities.

Altogether, we have kept our asset allocation steady and maintain a positive bias towards growth-sensitive assets, not only equities but also high yield and emerging market debt, while keeping our structurally short position in US Treasuries, Eurozone core government bonds and US investment grade credit. The reasons for this are that less central bank accommodation and rising inflation should translate into higher bond yields, while investment grade credit usually underperforms late in the cycle. The main change in our positioning this month relates to currencies, where we have added long US dollar positions on the back of an improving growth picture and the expectation that the Fed looks set to tighten. Speculative positioning looks excessively short as well. We expect a rebound after a very steady depreciation throughout 2017. However, we argue the best way to express a bullish view on the dollar is going long US dollar versus the Australian dollar and the Swiss franc, which look more vulnerable.

Risks aplenty, waiting for volatility to reflect

Price action has been very tame over the past few weeks, which has been reflected in volatility indices remaining at or near all-time lows across asset classes.

A number of event risks are lining up between now and year-end however. These, in spite of our confidence, include central banks’ decisions, in particular the ECB, the BoE and the Fed. Communication will be essential. The White House proposal about the next Fed chair could also result in a large market reaction if it implies a meaningful change of perspective.

Still, central banks have treaded carefully thus far and have made sure to communicate to the market the what, when and how of their QE exit.

Along these lines, investor surveys suggest politics is the top risk. On that front, the US fiscal reform looks like an upside risk from here given that market pricing is consistent with limited expectations. Progress on the US-led reform of the North Atlantic Free Trade Agreement (NAFTA) also looks worth monitoring as the Mexican peso has started to feel the pressure again.

The Catalonian crisis remains in flux as we write. The market has taken a benign view, to which we subscribe: the price action has remained very limited, with mild underperformance of Spanish assets compared to the rest of Europe.

As all this nearly looks too good to be true, do not expect central bankers to go on vacation just yet, as they remain the best guardian of stability.

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