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.

Will Strong DM Growth Lift EM Economies?

Robust growth in developed economies will not be enough to lift EM growth.

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The importance of U.S. and European economies to EM has declined tremendously since the late 1990s, while the importance of China and intra-EM trade has grown. But even in the late 1990s, booming U.S. and European growth was not enough to prevent crises in EMs. While U.S. import volumes will likely recover in 2017, this will not be enough to prevent an EM growth slump.

Instead of external demand, the domestic credit cycle is one of the main drivers of EM growth. Assuming credit growth in each individual EM country converges with its nominal GDP growth in the next 12 months, and in China’s case over the next 24 months, the 2017 projected EM credit impulse (equity market cap-weighted) will be negative. Historically, the credit impulse has been a good indicator for EPS growth.

Bottom Line: EM growth will disappoint and EM listed companies’ EPS will shrink in 2017.

Outlook For The U.S. Yield Curve

Our U.S. bond strategists expect the U.S. yield curve to steepen further in 2017.

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The steepening should be driven by improving growth, rising inflation expectations and a lagging Fed. We believe that the Fed will remain accommodative at least until TIPS breakeven inflation rates are in a range that is more consistent with the 2% inflation target. That range is between 2.4% and 2.5% for long-dated TIPS breakevens.

However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. We view a “dovish hike”, i.e. an increase in the fed funds rate with no upward revision to the Fed’s interest rate forecasts, as the most likely outcome. However, if we are wrong, an upward revision to the Fed’s forecasts would cause the curve to bear-flatten on the day.

At present, the market expects 59 bps of rate hikes during the next 12 months. If expectations remain at these levels until after next week’s FOMC meeting, they will be consistent with the Fed’s median forecast, assuming there are no upward revisions.

Also, as we pointed out in a previous Insight, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year.