The equity markets took an upturn again after a great deal of upheaval in May following escalating trade tension between China and the US, as China took retaliatory measures after the US authorities targeted Huawei.
The main western stock-market indices turned in performances of between 10% and 20% in 2019. After the Fed took an accommodative slant six months ago, valuations surged on the key US market as well as on emerging markets that are exposed to dollar trends, while Europe followed suit, driven by an undervalued euro. However, double-digit showings in 2019 are not attracting flows from end investors, and the hefty outflows from equity funds that began in the last quarter of 2018 continued: bond funds benefited as they are in a better position to take advantage of uncertainties on the world economy.
The Fed extends euphoria
US companies’ profitability has held up so far, but the downturn in business surveys is a harbinger for a slump in profits. EPS projections are for an 11.6% increase on a 12-month timeframe at this stage. These projections now seem to be jeopardized by the expected slowdown. However, share buyback programs’ accretive effects are persisting, pushing EPS up at a much faster pace than revenues and aggregate profits. Under current financial conditions, there are around $200bn in share buybacks each quarter and this factor provides considerable support for stock-market valuations, although the price to pay is an increase in financial leverage. The Fed has merely extended the euphoria by changing its stance and the S&P 500 is now trading on ambitious multiples of over 17x 12-month forward EPS, leaving little room for disappointment. Looking to the various business sectors, semi- conductors underperformed after sales worldwide took a nosedive following on from trade restrictions. The energy sector also plummeted with oil tumbling and prices coming close to US producers’ marginal cost of production (WTI at $52). The profit outlook in the sector is deteriorating severely, along with prospects in the basic materials sectors. However, on the flipside, US consumers’ resilience will help stocks in that sector outperform.
The S&P 500 is now trading on ambitious multiples of over 17x 12-month forward EPS, leaving little room for disappointment.
Despite the rebound in the euro area in June, fueled by Mario Draghi’s comments, the Euro Stoxx remains 30 points short of its January 2018 peak, while sluggish trading volumes also reflect the shortage of inflows on the asset class. Euro area equities are trading on around 13x 2020 EPS, so there is no clear discount. However, dividend yield remains attractive, with coupons paid out coming to 3.5%. At the same time, low volatility is promoting hedge purchases. We cannot rule out the possibility that institutional investors will cautiously revisit the asset class, especially with long-term bond yields at a low. Overall earnings momentum remains moderate and aggregate operating margins have narrowed more than a half-point over the past 18 months. From a sector standpoint, European banks are continuing to suffer. The new TLTRO III is not as advantageous as the ECB’s previous program and banks’ undervaluation to their net assets is getting worse. Basic materials and transport & leisure are sliding, in line with revisions to expected earnings, while sectors like utilities that are exposed to interest rates are performing better. The pursuit of quality and visible growth also remains a major investment theme. The personal care sector should continue to outperform, and more broadly speaking, defensive growth sectors will probably continue to outperform. A premium on quality stocks still looks warranted. However, equity investors are steering clear of the most shaky business models, despite high yield spreads narrowing considerably over the past several months. European indices are now set to fluctuate around their recent highs.
We cannot rule out the possibility that institutional investors will cautiously revisit the asset class, especially with long-term bond yields at a low.
Emerging markets shored up by a falling dollar
The Bank of Japan’s continued asset purchases have not curbed the decline in P/E multiples in Asia. The TOPIX is now trading on 2020 P/E of less than 12x. Expected growth is admittedly weaker than in other countries (+5% on a 12-month timeframe) due to downward pressure on operating margins across most sectors. However, there is an improvement in the payout ratio, with dividend yield on the TOPIX coming out at 2.5%. The Chinese stock-market has been dented by Trump’s protectionist measures, but the currency adjustment and China’s gradual reweighting in worldwide indices are helping stabilize share prices. Valuations of close to 11x show that a large number of risks are priced in. EPS growth is expected to come to around 12% over the months ahead. A positive outcome for the trade war will most likely trigger a recovery for Chinese equities. Broadly speaking, the dollar’s current decline will be good news for the emerging markets. To sum up, strong support from central banks is keeping equity valuations high, but end investors are steering clear of the asset class. Earnings expectations look optimistic in light of economic risks, but dividend yield remains a key argument in Europe.