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US equities - balance optimism with caution

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US equity indices have gained over the past six months, helped by optimism in the economy as well as a brighter outlook.

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"At Deutsche Bank Wealth Management, we stay cautious of US and global equity markets, even as we see some opportunities in Europe and emerging markets." - Tuan Huynh, managing director, chief investment officer, Asia Pacific Deutsche Bank Wealth Management

WITH US equities almost up double-digits year-to-date, Asian investors have been watching developments in two aspects: fundamentals and policies.

US equity indices have gained over the past six months, helped by optimism in the economy as well as a brighter outlook. Investors have priced in more fiscal spending to fuel infrastructure development, healthcare reforms and financial deregulation, following Donald Trump's election.

The question is whether this is sustainable or will there be some near-term correction.

Signs point towards some consolidation. Recent concerns about US policies were partially responsible for a 1.8 per cent decline of the S&P 500 on May 17, but it has since recovered and moved to record highs.

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Congress and the administration need to focus on the pro-growth agenda President Trump was elected to do. Keep in mind, the House has only 82 voting days left in the year and the Senate 93. This compares to 147 working days remaining for the private sector.

Given the short time and the aggressiveness of Republican-controlled Congress' agenda, we need to see some movement on tax reform, infrastructure, healthcare, and debt ceiling before getting more optimistic on equities at these heightened levels.

Meanwhile, the economic recovery has moderated lately. The Citigroup Economic Surprise Index, which indicates if data is coming in better or worse than expected, has fallen from a high of +58 in March to -77 in the week of June 19.

Data during the early part of the year is not unusual as this scenario has played out, on average, over the last five years.

However, as forecasts historically get tempered by mid-year, the probability of beating expectations grows. The good news is that the earnings outlook remains positive and is likely to remain supportive of equities.

At Deutsche Bank Wealth Management, we stay cautious of US and global equity markets, even as we see some opportunities in Europe and emerging markets. We don't expect a sharp correction, though. The S&P 500 has now gone 146 days without a 3 per cent correction - the eighth-longest streak dating back to 1945.

Contrary to the belief that the longer the rally, the harder (and larger) the pullback, we analysed the other seven longer rallies without a 3 per cent correction. Our analysis shows that following the eventual 3 per cent pullback, the S&P 500 was higher in five of the seven instances a year later. Of the two that are negative, the decline was a modest 3.9 per cent in addition to the original 3 per cent pullback.

As a result, long, uninterrupted rallies such as the one we have recently experienced do not necessarily result in a sustainable, negative correction.

Meanwhile, US yields have tightened. As the market watches for future rate hikes and economic data, yields are likely to head up again once fundamentals improve. Post the recent rate hike in June, we expect another to happen in December.

Credit will likely outperform sovereigns, in our view. While we continue to like credit (high yield and some emerging markets) in an environment of rising interest rates, solid credit conditions and an improving economic growth, returns may be muted by spreads already narrowing below their 15-year historical average and our 12-month targets. For example, current US high yield spreads of about 360 basis points (bps) are below our end-March 2018 forecast of 400 bps.

  • No assurance can be given that any forecast or target will be achieved.
  • The writer is managing director, chief investment officer, Asia Pacific Deutsche Bank Wealth Management.

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