The economic engine in Europe is humming: corporate profits are growing and the ECB is supplying the markets with lavish amounts of liquidity. The situation can only deteriorate in future – and it is precisely this scenario that is being discussed on equity markets at present, as reactions to the recent downturn in purchasing manager indices have shown.
Additional reasons for the persistently gloomy mood on equity markets were concerns about a future downturn in global trade, to which the U.S. government has made a significant contribution, as well as the recent Facebook scandal. President Trump is still a major factor in the prevailing sense of uncertainty, especially as he risks an escalating “trade war”, which would require the imposition of new customs duties by China and Europe. This has not happened to date. The scandal around the data breach at Facebook is likely to be an isolated case, as the other three companies in the “GAFA” group (Google, Amazon, Facebook, Apple) focus on a different business model and handle personal data better than Facebook.
In Europe, there are several political issues that need to be tackled in the foreseeable future. These include reforms in heavily indebted Italy, new aid for Greece but also the upcoming withdrawal of the UK from the EU. However, there is still time and the economy is flourishing.
We still believe that equities will perform well for another year or two. However, despite good fundamental data, it is to be expected that price fluctuations on equity markets will increase in future compared with the previous year, partly because market participants will question the prevailing opinion time and again. There are, however, no grounds for predicting a crash – neither has there been any intrinsic exaggeration on the equity market so far, as there was most recently in 1973/74 or 1999/2000.
The discrepancy between market sentiment and earnings performance is becoming ever more marked on the equity market as a result of prices consolidating. The European and German blue chips will generate record profits in 2018, which should send the DAX far higher by the end of the year. The valuation, at a P/E ratio in the DAX of 11.7, is favourable and the dividend yield (3.5%) is also attractive.
Valuation ratios on the U.S. equity market have also improved following the recent price correction and the sharp increase in (net) profits thanks to the tax reform, Valuations of U.S. blue chips, at a P/E ratio of just under 17 units, are only somewhat more expensive than their historical average.
It remains to be seen how central banks’ gradual withdrawal from ultra-expansionary monetary policy will affect equity markets. On average, U.S. companies have very high levels of debt, while European companies are less highly leveraged. However, as long as interest rates remain at a low level by and large and the economy continues to hum, equities will remain attractive, as they are fundamentally driven by corporate profits. There is only a risk of the economic upturn being stifled and equity markets falling if central banks raise interest rates too rapidly, as happened most recently in 2000 and 2007.
However, this shift towards falling prices on equity markets will not occur on an ad hoc basis. It is clear from the past that equity markets tend to periods of weakness once U.S. yields hit a level around five percent – perhaps even at a lower level in this cycle. For the moment, however, we do not expect yields to surge to such an extent.
What will happen next? There is much to be said for equity indices not recovering from the current setback until April. Ideally, rising corporate profits will then send equity markets back to their previous highs in early summer. As far as our country recommendations are concerned, the USA should still be underweighted, while Europe, Japan and the emerging markets look more promising. This assessment is, however, dependent on a global trade war being averted.