Is 2017 The Year Of The Letter “R”?

2017 will be dominated by a four ‘Rs’ theme: Recovery, Rates, Rotation, Re-leveraging, which will eventually lead to two additional ‘Rs’: Risk and Recession.

The global economy is in a modest recovery, whose roots predate the U.S. elections. The chart shows the number of times “reflation” has been mentioned in the news according to Bloomberg data. Such hype has been closely correlated with the extremely economic sensitive copper-to-gold ratio. Moreover, economic exuberance is signaling that global stocks have more room to run (top panel).

The back up in real yields is also noteworthy given the close correlation they enjoy with equities. Importantly, the U.S. 10-year TIPS yield has vaulted 47bps higher since the multi-year low hit just after Brexit, reflecting at the margin an improving economic growth outlook. Indeed, economic surprise indexes have firmed and financial conditions (as per Bloomberg) remain loose in every major region.

Another way to depict the reflationary effect on stocks is via a global equity EPS diffusion index. Using forward EPS data from I/B/E/S, we constructed a diffusion index of countries (both DM and EM) that have negative y/y EPS growth. This index has been steadily sinking since mid-summer with fewer and fewer country EPS in the contraction zone. This is a positive backdrop for global equities.

For additional details on the rest of the ‘Rs’, please refer to the Global Alpha Sector Strategy report titled ‘The Year Of The Letter “R”’, available at

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Outlook For EM Equities

The underperformance of EM equities has lasted for six years and is likely to persist for a while longer.


The previous cycle of EM underperformance suggests we could have a drawn-out bottoming process rather than a quick rebound. Emerging equities look like decent value on the simple basis of relative price-earnings ratios (PER), but the comparison continues to be flattered by the valuations of just two sectors – materials and financials. Valuations are less compelling if you look at relative PERs on the basis of equally-weighted sectors.

More importantly, the cyclical and structural issues undermining EM equities have yet to be resolved. The deleveraging cycle is still at an early stage, the return on equity remains extremely low, and earnings revisions are still negative. The failure of the past year’s rebound in non-oil commodity prices to be matched by strong gains in EM equities highlights the drag from more fundamental forces.

Bottom Line: We expect EM equities to underperform developed markets.