29 OCT.

2018

Asset Allocation , Asset Class

Equity market correction: Trying to buy the dip

Global equities have continued their early-October correction. Investors have become increasingly nervous about a likely peak in earnings momentum, faster rate hikes in the US, an on-going trade war between the US and China, and weak readings on European manufacturing. In this context, we continue to monitor all aspects of our constructive mid-term scenario, which, even though it has not been impacted, has become more fragile due to increased risks.

 

1. MACROECONOMIC BACKGROUND

Since the beginning of the year, the US economy has been growing faster than other developed economies. With the exception of residential investments, almost all economic engines are running at full throttle. Consumer and business confidence are high, wages are slowly creeping up and business investment continues to grow (although at a more moderate pace in Q3). Despite political turbulences, we still expect growth to be close to 3% in 2018, but to slow down in 2019 to 2.6% due to fading fiscal stimulus and higher rates.

The Eurozone economy has become a more mixed story, especially after publication of last week’s preliminary PMI manufacturing, which had declined further below consensus expectations, pointing to annualised GDP growth of only 1.6% at the start of the fourth quarter. Until now, hard figures have remained nevertheless constructive, with strong domestic demand, but the weaker exports and industrial production are being impacted by a more uncertain international environment and many risks. A possible rise in tariffs for cars, the possibility of a hard Brexit and the confrontational stance of the Italian government could all affect our moderately optimistic scenario, which foresees growth of 2% this year and 1.8% in 2019.

While some emerging economies (Turkey, Argentine) have been pushed into recession, mainly for domestic reasons, others should remain resilient, despite tightening USD liquidity. An escalating trade war and political tensions between China and the US affecting Chinese economic growth have forced Chinese authorities to loosen their monetary and fiscal policy in order to support domestic activity. This support should play out in the coming months and help stabilise most of the emerging economies.

In summary, we expect:

  • US growth to remain close to 3% this year and decelerate in 2019 to 2.6%.
  • Chinese economic growth to stabilise above 6% this and next year, thanks to policy support.
  • Eurozone growth to remain on track with 2% growth this year and 1.8% next year, even though the region’s economy remains exposed to many risks.

 

2. EARNINGS & VALUATIONS

In the meantime, the earnings season has progressed, with 32% of the S&P 500 companies reporting actual results to date for the third quarter. Around 85% have reported better-than-expected earnings growth, which is above the five-year average, resulting in a total year-on-year earnings growth of 23% so far. Companies’ guidance is, however, somewhat more cautious for the coming year, as profit margins might come under pressure due to higher input costs and interest rates. Taking into account the expected earnings growth for next year, and despite some margin pressures, earnings growth should remain positive.

In Europe, though it is still early to draw any conclusions, with fewer than 40 companies of the Stoxx 600 having reported earnings so far, around 45% of reported results have exceeded analyst estimates, according to Reuters. In a typical quarter since 2011, 50% beat analyst earnings estimates.

In the meantime, valuations are reasonable and could act as a cushion for equity markets. The US equity market quotes, after the recent correction and with upcoming earnings growth at around 16 times the expected earnings for the coming twelve months, while in particular emerging market and euro zone equities are attractively valued. 

In general, we believe:

  • Short-term positives come from above-consensus earnings for Q3 in the US.
  • Valuations are attractive and should act as a cushion for equity markets.

 

3. TECHNICAL MARKET ANALYSIS

Equity markets are clearly in correction mode. According to BoFaML, 63% of global stocks are in a bear market (vs. 70% at 2011 and 2016 index lows). We might thus be close to an interesting entry-point on a short-term period, if fundamentals remain constructive. This is confirmed by our technical analysis, which shows that we are close to some important key supports that might show a positive reaction. 

In general:

  • Equity markets are close to key supports and might show a positive reaction from these levels.
  • We continue to monitor those levels, as a downward break might result in changes being made to our short-term strategy.

 

4. RISKS

Volatility has already increased in recent weeks, with a Vix index of around 25% (against 11% at the end of September) that might stay elevated as, there is no shortage of potential volatility drivers, such as the US trade war with China, a possible EU-Italy confrontation, a peak in economic and earnings momentum and a stronger-than-expected slowdown in Chinese growth, a more hawkish Fed and the increased possibility of a hard Brexit. 

In general:

  • Despite a constructive fundamental and technical background, risks to our scenario remain clearly present.
  • We continue to monitor the possible evolution of (geo-)political risks and their impact on our base investment scenario.

  

5. Conclusion

Fundamentals, which are key to medium-term market performance, are still supportive:

  • The business cycle keeps moving forward.
  • Corporate earnings are still growing and equity market valuations look relatively attractive.
  • Our 1-year expected returns are even close to double-digit growth for equities.

We recognise several potential positive short-term performance triggers, despite well-known risk factors (trade war, a more hawkish Fed, earnings and economic momentum, Italy, Brexit and a stronger slowdown in Chinese growth):

  • The start of the Q3 earnings season, forcing market participants to look at fundamentals.
  • The re-start of stock buybacks in the coming weeks.
  • Equity markets are close to key supports. 

In general:

  • We are convinced that equity market risk/reward is attractive at current levels.
  • In this context, taking into account the technical support levels and fundamental triggers, we have decided to slightly increase our equity exposure to become slightly overweight in equities (from neutral).