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Dear Investors,
We have witnessed a continuous meltup of the market. Most observers spend
hours discussing whether this is Trumprelated or just an ordinary rebound of the
global economy.
We will not participate in this speculation,
but wish to note that the US market
is stretched when it comes to equity
valuations. At the same time, leading
indicators forecast a reacceleration of
growth in many economies over the next
6 months.
We also wish to highlight that volatility
has been very low. We would be surprised
if no tactical, short-term correction was
to materialise over the next few weeks
as markets are ahead of themselves.
From a purely economic point of view, the
profitability of corporates is increasing
and liquidity is abundant.
Inflation is returning and so is pricing
power. Let us enjoy this as long as it lasts.
Yours sincerely,
Yves Kuhn
Group Chief Investment Officer
Spring 2017
07/12
Valuations signal some
vulnerability
This US equity bull market is now the second longest ever,
up 225% since March 2009, shortly after Obama took office.
Age alone does not end the Bull – a
recession, catalysed by rising rates or
an exogenous shock, has set in shortly
after each major peak in the past 25
years. 2017 should bring balance sheet
strength, a return to earnings growth
after a two-year drought, and rising
interest rates.
The investment arm of Deutsche Bank has
stated that ‘the six-month change in the
global composite Purchasing Managers
Index (PMI) for new orders reached 2.5
points in January, the strongest positive
momentum in nearly five years’. This has
allowed US equities to rally by 9%, and US
10-year Treasury yields to move up by more
than 0.9% over the same period. All of these
moves are broadly in line with the change
suggested by key leading indicators, the
PMIs, suggesting the recent rally was
growth-inspired (rather than Trumpinspired).
Europe’s economy is also gathering steam.
For now, composite PMI levels for the
eurozone are already at 56 (a 70-month
high), which could come hand-in-hand with
a growth rate of 2% or more. Mario Draghi,
the European Central Bank (ECB) President
has declared victory over deflation after
consumer prices rose to 1.9% (just shy of
the ECB’s 2% goal). European sovereign
fund outflows have extended to a seventh
week as investors begin to shop around for
greater returns.
As Goldman Sachs stated: ‘High [US] equity
valuations alone are not a reason for
drawdowns in the short term, if they reflect
stable or improving macro conditions; but
they indicate elevated drawdown risk.’
The consistent and continuous melt-up
by the markets, triggered by a change of
flows from fixed income to equities, wrongfooted some investors.
The question is who gives in first: those
who are sitting on a 9% six-month return
or those who give up being by-standers and
want to jump into the market at any cost.
We will find out over the next few weeks.
The market seems to be ripe for tactical
correction, and the interplay between the
haves and have-nots currently seems to be
driving the market higher, inch by inch.
Yves Kuhn
Olivier Goemans
Chief Investment Officer
Head of Portfolio Management
BIL’s macro outlook for the next six months
Over the last six months, manufacturing
and employment strengthened in developed
economies, while inflation edged up across
the board, due in part to flattering base
effects and rebounding commodity prices.
The monetary policies of the major economies
continued to diverge, in line with their central
banks’ assessment of country-specific
circumstances. As stated by the Bank for
International Settlement, while the Federal
Open Market Committee (FOMC) raised the
target federal funds rate another quarterpoint, and hinted at a somewhat faster pace
of rate hikes, the ECB and the Bank of Japan
(BoJ) stayed committed to sustaining “lower
for longer”. Core fixed income markets and
exchange rates reflected this divergence.
Where does all this lead us?
Interestingly, US GDP growth of 4% would only
imply an upside of around 0.5 points for global
PMIs over the next six months. Higher commodity
prices and easing inflation are supporting a
recovery from deep recessions in Brazil, Russia
and various other commodity producers. For
the entire year, we stick to our forecast of 3.4%
2
for global economic growth, where half of the increase (0.25%) will be carried by
re-emerging markets such as Brazil and Russia, and the other half will be carried by
stronger growth in the US (2.4% according to the OECD) and Japan.
In the euro area, GDP growth will continue at the current modest pace (1.6%),
supported by accommodative monetary policy and moderate fiscal easing over
the coming years. There is room for more ambitious and effective fiscal initiatives
in Europe. There are encouraging signs that business investment may be
strengthening, but a high volume of non-performing loans (approx. EUR 1 trillion)
and labour market slack (EU unemployment at 9.6%) continue to hold back Europe’s
growth prospects.
In Europe, headline inflation has been pushed up by higher energy prices, but the
recovery is not yet sufficiently advanced to durably raise core inflation (0.9%). We are
below the non-accelerating inflation rate of unemployment (NAIRU), which seems to
be 5% for the US. For the moment, inflation is tame: US wage increases now stand
at approximately 2.8%, or in real terms around 0.5% on an annual basis. In Europe,
unemployment rates are rapidly dropping to under 10% (now 9.6%) and Nairu (9%)
should be reached within the next 12 months. Inflation is still mild, but the market is
beginning to price in rises in inflation.
Long-term interest rates have risen globally in recent months, although they remain
low by historical standards. In general, rates have climbed 0.5% to 1% this year. A sharp
reassessment by markets of the future path of interest rates could result in substantial
and widespread re-pricing of assets (e.g. real estate) that have been benefiting from
low bond yields. Note that European corporates have 10% lower leverage than their
US counterparts.
“
Banks are among the main beneficiaries
of the reflation theme
Equities
With US growth momentum nearing its peak and rates increasing further with a hawkish Fed, the potential for an equity correction
is growing increasingly stronger. At elevated levels of valuations, this also means more vulnerability to potential shocks.
European equities
Financial companies – banks in particular – remain the key beneficiaries of rising yields and increasing inflation, as shown in the
graph below. On the opposite side, defensive sectors such as real estate, utilities and consumer staples could continue to suffer.
5
Beta of European sectors to the German 10Y yield (1/1/2015 to 15/3/2017)
4
3
2
1
0
-1
-2
An increase in inflation is benefiting corporate
earnings, as a stronger top line and better pricing
are kicking in. Although higher rates usually
argue against multiple expansion, 2017 should
see some base effects materialising, driving a
strong rebound in commodity-related sectors’
earnings and a continued recovery in financials’
momentum. More broadly, there has historically
Real
Estate
Utilities
Consumer
Staples
IT
Healthcare
Consumer
Disc.
Materials
Telecoms
Services
Industrials
MSCI
Europe
Energy
Financials
-3
Source: Bloomberg, BIL
been a strong positive correlation between inflation rates and corporate earnings. The
Q4 2016 earnings season showed that European companies posted earnings per share
growth of around 8%, and should even experience acceleration throughout the year:
sell-side analysts are now expecting growth of 15% for 2017. Short-term sentiment, as
measured by the earnings revision ratio (number of upgrades – number of downgrades
/ number of revisions) is also largely in positive territory in Europe. That said the busy
election calendar is likely to bring some periods of uncertainty, as political risks remain
high in the region.
Evolution of earnings per share growth rates
Europe
US
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
Q1 15
Q2 15
Q3 15
Q4 15
Q1 16
Q2 16
On the back of this, we remain overweight on
value versus growth. We are overweight on the
consumer discretionary and industrials sectors.
The consumer discretionary sector – and autos in
particular – appear attractively valued, whilst being
highly leveraged to PMIs. We also favour a selection of industrial companies (namely US-exposed
infrastructure stocks), as we believe they might
benefit from the potential policy changes and
3
Q3 16
Q4 16
FY 2017
Source: JPM, IBES, BIL
stimulus following the election of Donald Trump. In addition, the sector should benefit
from an acceleration of global GDP growth, whilst trading at discount valuations to the
broader market. Within the growth market, we like the healthcare sector, as the sell-off
last year and subsequent de-rating offer good opportunities.
In the short term, we are neutral on financials. Banks are among the main beneficiaries
of the reflation theme and are still trading at a large discount to the European market
and their US counterparts, but the strong outperformance of the sector over the last few
months might come to a pause in the short term.
US Equities
Historically, when the composite ISM
(institute for supply management index, an
economic lead indicator) has moved above
56, as it did in January 2017, the S&P500 Index
was up in 100% of these cases over the next
six months. Equities remain under-owned
and there are some signs that this is starting
to change, with retail inflows finally coming
through.
The recent increase in yields helps the
broadening in sector and style leadership
and acts as an indicator of improving pricing
power, and should help bring about a shift in
asset flows: from deflation hedges (bonds) to
inflation hedges (equities). On the other hand,
rising yields do have a tendency to undermine
valuations in general. This is concerning given
that the US is already trading at a stretched
price-to-book premium that is two standard
deviations higher than its 10-year historical
average. However, we believe one needs to see
rising bond yields in order to stay constructive
in the mid-term. US wage growth is at its
highest in this cycle so far, and NFIB (National
Federation of Independent Business) intentions
to raise price indices have also moved to
elevated levels.
US earnings momentum has grown stronger.
The Q4 2016 reporting season showed
outright year-on-year earnings growth in the
US after five quarters of earnings recession,
with reported 6.3% earnings growth and 4.8%
sales growth, outpacing expectations by 2.6%
and 0.4%. This positive momentum could be
seen beyond the US, as European and Japanese
earnings outpaced US ones for the first time in
six quarters. The latest global manufacturing
PMIs are at their highest levels in 6-7 years,
which is consistent with double-digit EPS
growth.
President Trump and the Republican-controlled
Congress have publicly opined the prioritisation
of corporate tax reform. In aggregate, the
proposed lower tax rate (from 35% to 20%),
territorial taxation and the border adjustment
are expected to lift S&P500 EPS by 8 dollars
(+6%). This impact however could vary
significantly by industry.
Themes we would like to highlight in the US
are the beneficiaries of rising yields and Trump
policies. Financials are key beneficiaries of
rising bond yields and potential de-regulation.
Financials also stand to benefit the most from
lower statutory federal tax rates, while being
relatively insulated from the adoption of border
adjustment tax. Similarly, small & mid-caps
stand to benefit relative to large caps owing
to their higher domestic exposure. We believe
that the rotation out of growth and into value
sectors will continue as long as the bond yields
move higher and economic activity stays
elevated.
Japanese Equities
In Japan, we are also finally seeing signs
of a pick-up in inflation due to the base
effect of increased energy prices. With the
unemployment rate at 3%, its lowest level
since the 1990s, the stage could be set for
future wage growth and higher inflation in
coming months.
The Bank of Japan continues to target a steeper
yield curve. The stronger the sell-off on the US
Treasury market, the greater the potential for
the market to test Kuroda’s resolve to keep 10year Japanese government bond (JGB) yields
at 0%, essentially forcing the Bank of Japan to
4
buy potentially unlimited amounts of JGBs. The
prospect of such an outcome should put further
downward pressure on the yen and brighten the
outlook for corporate profits.
Historically, one of the many challenges
facing Japan has been a relatively unprofitable
corporate sector. That is in the process of
changing. Improving corporate governance
coupled with increased share buybacks has
pushed the notoriously low return-on-equity
(ROE) up to around 7%. While still low by US
standards – partly the reflection of a multidecade deleveraging by Japanese corporations
“
European
and Japanese
earnings
outpaced US
ones for the
first time in
six quarters
A key
question for
European
rates is
when the
– this is well above the 20-year average of 4%.
While Japanese stocks bottomed in 2012, Japan
remains reasonably priced in contrast to the US,
just about every other developed market and
even many of the emerging markets in Asia.
While other markets, notably the United States,
have seen prices driven primarily by multiple
expansion, Japan has benefited from rising
earnings.
US, the price-to-earnings (P/E) ratio on the S&P
500 Index has risen by roughly 75% since the
market bottomed in 2009. In contrast, since
bottoming in 2012, Japanese equity valuations
are relatively flat. As a result, Japan remains a
value play in an increasingly expensive world.
It is revealing to compare the bull market gains
in the United States to those in Japan. In the
ECB will
start to
taper
Fixed Income
Looking at the shorter term interest rates, it is evident that Europe and the US still live in very
different economic and political environments.
Using two-year interest rates (other short-term
rates could be used just as well), we see that
the US rate has continued to climb steadily.
On the fundamental side, this is a reflection of
the already strong economic environment and
expectations of further rate hikes from the
Federal Reserve.
In Europe on the other hand, the rate has
been pushed down even further. Even if the
economy is improving here as well, we are not
yet on strong and sustainable footing; the ECB
continues with its forward guidance of low
rates.
Due to the differing directions of the short-term
rates, the yield curves of Europe and the US are
taking on different shapes. As discussed earlier,
this is important because the yield curve has a
large impact on the earnings of various sectors.
In Europe, the yield curve has been clearly
steepening. Normally, this indicates stronger
economic growth, but if we look closer at the
time period after the immediate effect of
Trump’s victory, we see that the steepening
is mainly caused by short-term rates moving
even further into negative territory (from
-0.6% to -0.8%). History will tell whether the
traditional conclusions can be drawn in this type
of unprecedented situation. Unfortunately, we
feel one cannot be too optimistic at this time,
as the main cause is ECB bond buying and
political uncertainty. In any case, we do expect
the EUR yield curve to continue steepening:
slightly higher long-term rates should climb
somewhat, while short term rates are low (but
not decreasing further).
In the US on the other hand, the yield curve
has been flattening. Short-term rates have
increased more than long-term rates. This is
due to expectations that the Federal Reserve
will hike short-term rates, while the market
is still not convinced inflation will increase
dramatically. However, Trump’s planned fiscal
spending should lead to a larger increase in
5
long-term rates and a steeper yield curve. At the
moment we believe that is more of a story for
2018 than 2017.
Despite these differences in the yield curves,
we do expect increasing rates in general, which
means that one has to pay attention to interest
rate risk and focus on investments with short
or medium duration. This is especially true for
USD investments, where we favour floating
rate exposure to benefit from the increasing
short-term rates and avoiding interest rate risk
completely.
A key question for EUR rates is when the ECB will
start to taper and end its bond buying program;
how it communicates this will be crucial. Current
expectations are that the ECB will continue with
quantitative easing in some shape or form next
year, but at decreased volumes. The market is
already starting to speculate about when the
ECB will comment on this; most probably it will
not happen until after summer. At some point,
the market will start to price in a tapering of
some sort, which would add further pressure on
increasing rates and perhaps more importantly
affect credit spreads as the ECB has also been
buying corporate bonds. This means that one
ought to be very selective when investing in
EUR credits, both investment grade and high
yield – as the margin of error is very small due
to the low yields.
We prefer equities (inflation
hedge) rather than bonds
(deflation hedge)
Conclusions
Let us summarise our views:
-We prefer equities (inflation hedge) rather than bonds (deflation hedge). An interesting momentum is being generated by the renewed
pricing power of corporates through steepening yield curves, while equities are highly valued.
-European and Japanese equities should benefit more than US equities from a re-acceleration of the US economy. In addition, we
continue to think accommodative policy in Europe and Japan will support those markets, while rising yields and policy disappointments
will weigh on the US market.
-There is favourable economic momentum in Australia and Japan, and we are happy to have an exposure to the MSCI Pacific region.
-We are selling our exposure to European high yield securities (yield to maturity 2.7%), as we believe that the yield does not adequately
reflect the risk of this asset class. We are taking into account the planned tapering by the ECB later this year.
-In addition, we think the sovereigns of core European countries are overpriced.
In the short term, the FED might surprise with activity, and:
- We might see a flattening of the US yield curve over the next 6 months, as the short end moves up.
- In the longer run, however, there might well be a steepening, and this would be beneficiary to financials and value-style investments.
- Any relief rally resulting from the French election not bringing about increased risks will provide some mighty tail winds to the euro.
Despite experiencing some volatility in the short term, the euro might finish the year at a similar level to where it started in relation to
the USD; indeed, the euro might even gain ground versus the USD.
A more stable dollar and trend-like global growth create a benign backdrop for emerging markets and commodities alike; this would lead
us to close our EM equity underweight and maintain a neutral stance on commodities.
3 to 9 months investment horizon
Asset Class
• The global growth outlook is slightly accelerating.
• We are overweight on European and MSCI Pacific region
equities.
• Reflation trade will push up yields worldwide.
• We remain underweight on government bonds/duration and
expect at least two rate hikes in 2017.
• 'Make America great again' with a revamp of fiscal policies.
• We prefer US Small Companies compared to the large
companies that have more international sales.
• The ECB will taper sooner or later over the next 8 months.
• We are selling European High Yields Bonds (YTM 2.7%) and core
government sovereign bonds.
• Inflation is back, interest rates are going up.
• We are increasing exposure to interest-leveraged sectors such
as financials, and limiting exposure to real estate.
Yves Kuhn, Group Chief Investment Officer
As economic conditions are subject to change, the information and opinions presented in this outlook are current only as of March 16, 2017. This publication is based on data available
to the public and upon information that is considered as reliable. Even if particular attention has been paid to its content, no guarantee, warranty or representation is given to the accuracy
or completeness thereof. Banque Internationale à Luxembourg cannot be held liable or responsible with respect to the information expressed herein. This document has been prepared
only for information purposes and does not constitute an offer or invitation to make investments. It is up to investors themselves to consider whether the information contained herein is
appropriate to their needs and objectives or to seek advice before making an investment decision based upon this information. Banque Internationale à Luxembourg accepts no liability
whatsoever for any investment decisions of whatever nature by the user of this publication, which are in any way based on this publication, nor for any loss or damage arising from any
use of this publication or its content. This publication may not be copied or duplicated in any form whatsoever or redistributed without the prior written consent of Banque Internationale
à Luxembourg.
This publication has been prepared by: Banque Internationale à Luxembourg ı 69, route d’Esch ı L-2953 Luxembourg ı RCS Luxembourg B-6307 ı Tel. +352 4590 6699 ı www.bil.com
DMO209901-EN-04/17
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