“Price Tag” – Jessie J, 2011

A year ago, tighter monetary policy, heightened political risks and decelerating macro forces wrong-footed investors as US stocks fell 20% over Q4 2018. Then, one after the other, these headwinds retreated exactly in the order they appeared, starting with monetary policy. US stocks reacted strongly, delivering a performance of around +32% since they bottomed. However, we believe the problem we are now facing is of a different kind: the current recovery has led many equity indices to look expensive. While we have been positive on stocks since early September due to macro stabilisation and overly pessimistic market sentiment, we are now not as positive as before. Is it time to call everything expensive and shop for assets based on their price tag, or are we likely to see a prolonging of this everything-rally period? We see a more limited upside from now, without changing our bullish positioning.

What’s Next?

What Recession?

Growth drivers have stabilised considerably since June, following the end of the slowdown that started in January 2018. The “mid-cycle” pause called by Fed Chair Jerome Powell has led to a one-of-a-kind situation: world growth remains decent while monetary policy has become once again incrementally more accommodative. This is due to an unlikely combination of factors. First, the trade war between the US and China led to a 3.5% net contraction in global trade between October 2018 and June 2019. Historically, contractions in global trade are reliable recessionary indicators. In 2001, global trade contracted by 6%, by 20% in 2008 and by 2% in 2015. Little wonder central banks adopted a change in tone from unwinding quantitative easing to further easing across the G10 world. The spectre of recession was looming and a prudent reaction was required. In the meantime, the Eurozone was indicating strong signs of deceleration, particularly in historically more robust economies such as Germany. But all of that is now behind us, or so it seems. Private sector economists expect the global economy to grow by 3.1%, 3% for the IMF and 2.9% for the OECD and the World Bank. Did someone say recession? The robustness of the growth has of course a lot to do with the solidity of developed world consumption: +2.6% this year in the US, +1.2% in the Eurozone and +0.9% in Japan. These numbers are dwarfed by +8% in China, but they provide a strong guarantee that we will not see a recession in 2019 or the beginning of 2020.

This satisfactory macro situation has been largely confirmed by corporate earnings this year. S&P 500 company sales have grown by more than 3% each quarter, while analysts expect Q4 to be a bottom before sales growth resumes above 4%. In the case of the Eurostoxx 600, sales grew every quarter by at least 1%. The same holds true for many developed economies. Any earnings contraction witnessed this year came mainly from tighter margins.

Valuations are Higher than You Think

If valuations were attractive in early September, the current situation is different, in our view. Equities have rallied sharply since then, leading most regional indices into higher territories. Using a discounted cash flow model, we can turn the price of regional indices into a 12-month implied earnings growth rate. By doing so, we can judge the expensiveness of equities in relation to the current dynamism of the economy. What is the outcome of this analysis? A mixed picture: the MSCI World index needs to see its earnings growth reach 18% over the next 12 months, driven by US stocks now expecting 24% earnings growth and European stocks, 21%. These numbers are consistent with other valuation metrics: when looking at a cross section of indicators, US and European stocks are expensive. The S&P 500 index sits in its 87^th valuation percentile across a large number of metrics. According to our estimates, this usually leads to a -4.5% correction over the following three months. The Eurostoxx index has now reached its 81^st percentile: European stocks are no longer cheap and have now reached the valuation danger zone, similar to US stocks. Only emerging and Japanese stocks remain cheaper, with limited expected earnings growth.

Are equities the only asset at valuation risk? We do not think so. We look at valuation relative to other risk premia and history, based on carry. This analysis shows that credit (investment grade and high yield) spreads are historically tight. Indeed, most hedging instruments, such as government bonds, gold, inflation breakevens, the yen and the Swiss franc, are equally expensive. What makes this situation exceptional is that everything looks expensive to some extent: both hedges and growth-oriented assets. We think that current valuations are probably the number one risk to our still-positive scenario.

Sentiment: the Game Changer?

Sentiment could be the game changer. In the case of equities, high valuations could well become justified by continued macro improvement. If price/earnings ratio expansion becomes justified by strong earnings growth, then the equity rally will continue and hedging assets will be at risk in the coming months. Why is that so? Mainly because the last leg of this year’s equity rally happened with a low participation rate: cash remains king for now in spite of low-to-negative rates. According to our estimates, the multi asset fund industry’s beta to equities remains lower than a year ago, highlighting a lack of investor conviction. Nothing grows forever but earnings growth is likely to continue over Q4 this year and into Q1 2020. If we are right and investors get caught in this late equity fever, the rally is not over yet. This valuation risk has only created a more limited upside potential for now unless we see a large and ample growth improvement.

That is where the surprise could come from. Analysts have, on average, a very different view of earnings growth. Throughout the year, their growth forecasts for earnings have decreased continuously (as usual), reaching zero to negative values. On average, analysts are expecting a profit stall. Expectations are most negative for emerging stocks – analysts expect a 10% contraction in profits in 2019. In the case of Europe, this number is around 0.5%, and 2% in the US. Should these expectations be proven wrong, valuations would be amply justified.

For all these reasons, we maintain our positive stance towards growth assets and will probably do so until we see a material deterioration in the growth situation. We have started adding hedges against a fall in equities. Yet, given the fact that investor hedge positions are still large, we still expect a constructive investor attitude in the event of a drop in equities.

Important Information

Past performance is no guide to the future, the value of investments, and the income from them change frequently, may fall as well as rise, there is no guarantee that your initial investment will be returned. This document has been prepared for your information only and must not be distributed, published, reproduced or disclosed by recipients to any other person. It is neither directed to, nor intended for distribution or use by, any person or entity who is a citizen or resident of, or domiciled or located in, any locality, state, country or jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. This is a promotional statement of our investment philosophy and services only in relation to the subject matter of this presentation. It constitutes neither investment advice nor recommendation. This document represents no offer, solicitation or suggestion of suitability to subscribe in the investment vehicles to which it refers. Any such offer to sell or solicitation of an offer to purchase shall be made only by formal offering documents, which include, among others, a confidential offering memorandum, limited partnership agreement (if applicable), investment management agreement (if applicable), operating agreement (if applicable), and related subscription documents (if applicable). Please contact your professional adviser/consultant before making an investment decision.

Where possible we aim to disclose the material risks pertinent to this document, and as such these should be noted on the individual document pages. The views expressed in this document do not purport to be a complete description of the securities, markets and developments referred to in it. Reference to specific securities should not be considered a recommendation to buy or sell. Investors shall conduct their own analysis of the risks (including any legal, regulatory, tax or other consequences) associated with an investment and should seek independent professional advice. Some of the investment strategies described or alluded to herein may be construed as high risk and not readily realisable investments, which may experience substantial and sudden losses including total loss of investment. These are not suitable for all types of investors.

To the extent that this report contains statements about the future, such statements are forward-looking and subject to a number of risks and uncertainties, including, but not limited to, the impact of competitive products, market acceptance risks and other risks. Actual results could differ materially from those in the forward-looking statements. As such, forward looking statements should not be relied upon for future returns. Targeted returns reflect subjective determinations by Unigestion based on a variety of factors, including, among others, internal modeling, investment strategy, prior performance of similar products (if any), volatility measures, risk tolerance and market conditions. Targeted returns are not intended to be actual performance and should not be relied upon as an indication of actual or future performance. 

Data and graphical information herein are for information only and may have been derived from third party sources. Unigestion takes reasonable steps to verify, but does not guarantee, the accuracy and completeness of this information. As a result, no representation or warranty, expressed or implied, is or will be made by Unigestion in this respect and no responsibility or liability is or will be accepted. All information provided here is subject to change without notice. It should only be considered current as of the date of publication without regard to the date on which you may access the information. Rates of exchange may cause the value of investments to go up or down. An investment with Unigestion, like all investments, contains risks, including total loss for the investor.

Unigestion UK, which is authorised and regulated by the UK Financial Conduct Authority, has issued this document. Unigestion SA authorised and regulated by the Swiss FINMA. Unigestion Asset Management (France) S.A. authorised and regulated by the French Autorité des Marchés Financiers. Unigestion Asia Pte Limited authorised and regulated by the Monetary Authority of Singapore. Performance source: Unigestion, Bloomberg, Morningstar.