02 MAY.

2019


The temptation to apply the old stock market adage is stronger than ever this year. The main equity markets have gained 12 - 20% since their lows in December 2018, which corresponds to relatively unrealistic annualised yields for 2019. The equity market rally cannot sustain the same pace over the coming months. When should we be getting ready to take profits and more significantly reduce our equity exposure?

The markets are proving particularly resilient, underpinned by very strong positive momentum which may persist further. The equity rally over the past 4 months has only just fully recouped the heavy losses recorded during the last quarter of 2018. Only the US market has posted gains of 10% over 12 months, with the European and Japanese indices standing close to their levels recorded at the end of April 2018, while emerging markets remain in negative territory. Equity valuations are therefore not excessive, with the US market trading on a price/earnings ratio of 17.5, compared to an average of 17x over the past 20 years. The U-turn in monetary policy by the US central bank is underpinning higher equity valuations. The Fed has (perhaps temporarily) interrupted its rate hike cycle, while its balance sheet reduction programme is scheduled to come to a halt in September. Interest rates remain low in the absence of inflationary pressure, making equities relatively more attractive than bonds, as the risk premium for the US market is now largely positive at +3% and above its historic average of 2.5%. The gap is even wider in the European market, with a 7% risk premium over German 10-year yields. Improved economic data after the sharp slowdown recorded at the end of last year is therefore driving equities higher. Caution is another factor which may continue to support the equity rally, as investors appear to have missed part of the upswing. Equity markets are therefore not yet characterised by excessive optimism.

What can reasonably be expected? Upside vs downside risk has clearly become more asymmetric. A further 4 - 5% can be expected under a bullish scenario based on rising equity indices, whereas a return to last year’s lows would involve a fall of 20%. As corporate earnings growth is expected to be relatively sluggish this year, market upside is based chiefly on a lower equity risk premium and therefore higher valuations. However, the risk premium is falling despite many risks remaining present. Most of these risks are political, including the outcome of the negotiations between the US and its key trading partners, along with the European elections and the Brexit. Central bank monetary policy credibility is another risk factor for the second half of the year. Investors are now expecting the Fed to cut rates next year. What will they anticipate however if economic indicators improve and inflation picks up? Will the Federal Reserve’s communication remain as credible? The ECB will be nominating a new president in the autumn and will also face the challenge of maintaining its current credibility, which is essential for eurozone stability.

We are therefore positioned in anticipation of equity market consolidation, while if any sign of excessive optimism arises or conversely, if any risks materialise, we will adopt an even more cautious approach and further reduce risk in our diversified funds. Meanwhile, we have perceived no signals indicating that we should sell in May, other than the adage itself.