Outlook For EM Equities

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

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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.

U.S. Banks: Higher Rates Vs Weaker Loan Growth

Bank stocks have experienced a sentiment-driven surge since the U.S. election, supported by expectations for higher interest rates. Lost in the exuberance has been a marked deceleration in credit creation.

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Total bank loan growth has dropped to nil over the last three months, led by the previously booming C&I category. That is a sign that while businesses are expecting an economic improvement, they are not yet positioning for one via increasing working capital requirements. Coupled with increased bank staffing levels, the growth in bank loans-to-employment, a decent productivity proxy, has also dropped to zero. Importantly, the yield curve steepening trend has taken a breather, which may be a catalyst for some profit-taking.

Bottom Line: Our U.S. equity strategists are underweight banks.

Global Equities To Trend Higher

Although a short-term correction is likely, the current reflationary window should provide a tailwind for global equities in 2017.

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We expect global equities to be higher in 12 months than they are today. However, the risks for stocks are tilted to the downside over both a shorter term horizon of less than two months and a longer-term horizon exceeding two years.

The near-term outlook is complicated by the fact that global equities are overbought, and hence vulnerable to a selloff. Our bullish sentiment indicator is stretched to the upside. Expectations of long-term U.S. earnings growth have also jumped to over 12%, something that strikes us as rather fanciful. Renewed rumblings in China could also spook the markets for a while.

We expect global equities to correct 5-10% from current levels, setting the stage for a more durable recovery. Once that recovery begins, higher-beta developed markets such as Japan and Europe should outperform the U.S.

Outlook For Euro Area Growth

The European economy grew at an above-trend pace in 2016 and should do the same in 2017.

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Euro area growth should remain reasonably strong in 2017, as telegraphed by a number of leading economic indicators. Fiscal austerity has been shelved in favor of modest stimulus. The European Commission is now even advising member countries to loosen fiscal policy more than they themselves are targeting.

Ongoing efforts to strengthen the euro area’s banking system will also help. As banking stresses recede, the gap in economic performance between northern and southern Europe should narrow. The overall stance of monetary policy will facilitate this trend. If the ECB keeps interest rates near zero for the foreseeable future, as it almost certainly will, Germany’s economy will overheat. Higher wage inflation in Germany will give a competitive advantage to Club Med producers seeking to sell their goods in the euro area’s biggest economy and will help erode Germany’s current account surplus.

Bottom Line: Stronger euro area growth rests on the assumption that Germany accepts an overheated economy. This will clash with Germany’s historical antipathy towards inflation, meaning that political risk could escalate over the coming years.

Bond Sell-Off Will Undermine U.S. Equity Returns

Even a mild version of 1994 U.S. bond sell-off could undermine equity returns.

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Apart from the 1994 episode, there have been three other major Fed tightening cycles since 1985. In each case, the 10-year Treasury suffered an almost 10% or more annual loss, either following or just before short-term rates began their ascent. Investors underestimated the pace and extent of rate hikes every time and equity returns also faltered. This was the case even when the Fed telegraphed a modest and steady 25 basis point-per-meeting pace of rate hikes from 2004-2006.

The point is that even a mild version of 1994 could undermine equity returns. Indeed, the risk is that investors have pulled forward profit growth expectations due to anticipated fiscal stimulus (that may disappoint) at a time when domestic monetary conditions are tightening. EPS growth is significantly lower today than in 1993, and the gap between trailing earnings growth and 12-month forward expectations is wide. This suggests that there is a greater risk of earnings disappointment than was the case in the early 1990s. Meanwhile, equity valuations are significantly higher today. The risk is that the longer the uptrend in stocks continues without interruption, the greater the pullback will be should economic performance disappoint.