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Valuation challenge

US equity values remain stretched and could underperform global markets in 2018


THE higher likelihood of a tax reform and strong leading indicators underpin the better growth prospects that US equities have been pricing. Small caps, which tend to be more domestic and less tax-efficient than large-cap companies, have performed well on the hope of tax cuts. Value stocks have also outperformed growth stocks partly for those reasons but also as yields moved higher. Value stocks tend to indeed benefit from higher yields while growth stocks are penalised by the higher discount rate applied to their growth. While we do not expect USD yields to substantially move higher in Q4, the flip side to the solid growth picture is more volatility in rates expectations which could weigh on the US equity market.

US economy is on a good trajectory

On the economic front, the US economy is on a good trajectory, with employment expanding and private consumption and corporate spending increasing. Monetary conditions, helped by the rally in equities and the fall in the USD this year, are still accommodative. While any fiscal stimulus in the coming months remains uncertain, the mid-term elections provide an incentive for the Congress and the White House to agree on some kind of tax solutions. But even without that, growth should remain healthy in the US.

While a tight labour market could lead to higher wages and weigh on corporate margins, a potential corporate tax cut could lead earnings estimates to be revised higher for 2018. Also, a potential one-off tax holiday for cash held overseas could lead to increased M&A, dividends and share buyback activities. Deregulations, another important focus of the US administration, could be a positive catalyst for US equities in the coming months.

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Expect Fed to hike policy rate twice in 2018

We anticipate that the US central bank will raise rates twice in 2018 in addition to a rate hike expected in December this year. In July, the US Federal Reserve (Fed) submitted its semi-annual report on monetary policy operations to Congress. The report's summary on monetary policy distinguished between interest-rate policy and balance-sheet policy and clarified the central bank's stance of closely monitoring inflation trends as part of interest-rate policy.

Yields on US Treasury bonds have risen and the US dollar has also enjoyed a robust rise due to the recent improved outlook for US tax reform, but a specific tax-cut plan sufficient to justify a rise in interest rates is yet to coalesce. We continue to maintain a neutral stance on the US dollar as the market has already digested the Fed's upcoming rate hike in December.

We do not expect the announced reduction of the Fed's balance sheet to have a significant impact on the direction of the equity markets overall. Barring a situation in the near future where the Fed tightens monetary policy too fast and derails the global economy - which is clearly not our base case - the synchronised global growth momentum remains the main driver for earnings and market.

Low expectations should result in positive surprises

There are good reasons to expect a relatively solid Q3 results season. Bottom-up earnings growth expectations are pretty rational (the high growth expectations for the materials and energy sectors are set to increase from pretty low levels) and in our view, are reachable or even beatable. Despite uncertainties related to hurricanes, we believe that we should see positive EPS surprises. Based on consensus estimates, companies in S&P 500 are expected to grow their EPS by 5 per cent year on year (YoY) in Q3, compared with 14 per cent in Q1 and 11 per cent in Q2. Six months ago consensus had expected Q3 YoY growth to be closer to 10 per cent. With expectations being relatively cautious now, especially when taking into account the strong macro backdrop, we believe we are likely to see most companies beating expectations.

Limited upside potential

However, valuations remain stretched in the US, more so than in other markets. Part of the aforementioned improvement in earnings could lead to a small contraction in multiples, ie the increase in earnings could not fully translate into price upside. The reason for this is that high multiples have been justified by record-low bond yields and rates, but with the Fed expected to hike twice in 2018, we see yields slightly higher than today in 12 months and would therefore expect multiples to contract slightly as well. Therefore, we expect US equities to underperform global markets as lower terminal growth rates and already depressed risk premiums will limit total return prospects for US equities.

Energy and telecoms could benefit

Among the sectors we currently like, energy and telecoms are the most likely to outperform on the back of the Q3 reporting season. The energy sector has benefited from a rebound in oil prices and has been the second-best performing sector in Q3.

Despite this strong performance, the sector has lagged year to date, and we think the reporting season could lead to outperformance. The cost-cutting measures that energy companies have implemented should start to show up in numbers, and the improving margins could push energy stocks higher. In telecoms, we believe that there could be a repeat of outperformance seen during the Q2 earnings season.

Healthcare, another sector we like, is probably facing more uncertainties related to earnings. Pharmaceuticals companies in general, and medtech in particular, have facilities in Puerto Rico, and the hurricane might affect their Q3 results. Also, the weaker USD YoY is a slight headwind in our view. But, overall, numbers should still be reasonably good.

One sector that could provide some surprises is financials. Uncertainties related to hurricane damages are significant, especially for insurance, but banks might have fared slightly better than what consensus estimates expect. With low visibility on the overall sector, we would prefer to stay neutral overall. W

John Woods is chief investment officer Asia Pacific, Credit Suisse.