Cautiously optimistic

Our primary focus over the next twelve months is sectors rather than countries

Let's get straight to the point: breaking with recent precedent, we did not raise our price targets for the benchmark equity indices at our latest strategy meeting. This is remarkable for two reasons. First, our GDP forecasts for 2018 and 2019 are virtually unchanged because the global economy remains robust, the unemployment numbers continue to decline, the purchasing managers are still confident and many companies are still sitting on a mountain of cash. Only recently, four large U.S. financial institutions announced their intention to distribute $110 billion to their shareholders via dividends and share buybacks. The late cycle is, therefore, alive and well, and it would appear we do not have to fear neither overheating nor rapidly rising interest rates. Second, this macro and financial constellation should, on the basis of our normal forecast process, mean that we raise our price targets by 2-3%. Why? Our price targets are valid for a 12-month timeframe. Since we revise them every quarter, our assumption of average earnings growth of roughly 10% until summer 2019 translates into growth of roughly 2.5% per quarter. Based on an unchanged price-to-earnings (P/E) ratio, our price targets would therefore have to be increased by 2.5% every quarter.

Why then are our targets largely unchanged? Primarily because we have lowered our target P/Es slightly. It is only for the emerging markets that we have also reduced projected earnings growth slightly. We are, therefore, extrapolating a development that has been noticeable in recent quarters in many equity markets and for some months now even in the vigorous U.S. market: falling P/Es. Lower multiples are, therefore, being applied to corporate earnings, whether realized or projected, to determine stock prices. This means that, over the medium term, investors expect either lower earnings, a higher discount rate, or a higher risk premium. We think that currently it is a combination of the first and third expectation. Despite the lack of tangible evidence, more and more investors expect the business cycle to end in 2021 at the latest. The end of the cycle could be brought forward, however, by the reduction in central-bank balance sheets (which is expected to begin this year), the ongoing trade dispute and Trump's comments on individual sectors and companies, China's bubbly housing market or by major distortions provoked by high corporate and sovereign-debt levels. Even though these risks are not built into our base scenario, we can no longer ignore them entirely in our forecasts. Our primary fear is that U.S. shareholders have been cherry-picking from the U.S. administration's policy assortment – focusing, for example, on tax reform and deregulation. This is readily apparent in the Russell 2000, which is geared more to the domestic market. Since the beginning of February it has clearly outperformed both the Chinese and the German market – the CSI 300 by 28 percentage points and the Dax by 17.

Alongside companies with a strong domestic bias, tech stocks have again been driving the U.S. market. The ten companies with the biggest absolute gain in market capitalization in the first half of the year are all tech-centric. Their market cap has increased by some $700 billion. To put this number into perspective, this is equivalent to almost half the market cap of the Dax. But a comparison with the $298 billion market-cap increase for the S&P 500 also shows how the tech giants are steadily cementing their dominance. As ABBA, the Swedish pop group, sang in 1975 "The Winner Takes It All". This seems to have worked for some tech firms for the past years. Some anti-trust or other government agency is, however, likely to step in one day. While this might take some more time, we believe investors are starting to anticipate such a step. Declining P/E ratios might be an indication for this. We are also becoming more selective with tech firms. But if history is any indication, the sector might be supported by investor behavior: in the past, they haven't changed their favorite sector before the rally hit the wall. Next to tech stocks, we also favor financials and European small/mid caps over the next twelve months.

Given the strength of tech stocks, it is no wonder that after the first half of the year the Nasdaq is leading the pack among the few indices that are still in the black. Most indices are in the red. China's CSI 300 and Argentina's Merval have even reached correction territory already – trading at least 20% below their highs to date. Brazil's Ibovespa is not far behind. Alongside the strength of the dollar, rising U.S. interest rates and global trade issues, the weakness in some emerging markets is attributable to idiosyncratic problems, and so we do not believe the weakness is systemic. We continue to judge that especially Asian emerging markets are in good fundamental shape and that their valuations seem attractive following the last correction. On top of that, we think the dollar will not continue to strengthen at the same pace and that 10-year U.S. yields are near their peak for the cycle. All this should relieve the pressure on equities.

Even U.S. shareholders have recently become more cautious

P/Es have been declining for some time now. Last to join was the S&P 500 whose data has been distorted by the tax reform, however.