What is the upside?

Credit Suisse raises our year-end targets to 2,250 and 3,100 for the S&P 500 and Euro Stoxx 50 from 2,100 and 2,950, and introduce mid-2017 targets of 2,300 and 3,200.

We would, however, anticipate a sell-off in equity markets in the second half of 2017. We stick to our benchmark weighting of equities.

What has improved: 1) The ERP is too high. The warranted equity risk premium (driven by credit spreads and ISM) has fallen to 5% while the actual equity risk premium is 5.8%. The risk may be a sell-off in credit (given credit risk appetite is in euphoria), but we struggle to see a meaningful sell-off given market-implied non-oil default rates are double those occurring, and the ECB and BoE are buying corporate credit. 2) Many US lead indicators of IP, capex and employment are now turning higher. In addition, we have had the longest period of inventory decline since the 1950s. 3) There appear to be clear hints of fiscal easing from policy makers in the US, UK and Japan.

What has remained supportive for equities: 1) Most financial proxies on cyclicality are consistent with flat to a modest slowdown in GDP growth, yet global PMI new orders, at a five-month high, imply a mild rise in global GDP growth. 2) Excess liquidity is running at 8% (and implies a c.30% rerating).
3) Central bank policy. We continue to believe that central banks will continue to err on the side of caution and risk an inflation overshoot rather than risk recession (the template being the Riksbank). 4) Long-term positioning remains cautious: US equity mutual fund selling has been extreme. The corporate sector has been the only buyer, resulting in low equity weightings by institutions, and there is now a record $1.4trn of dry powder available to private equity (which could thus buy 5.5% of market cap). 5) Most bull markets end on clear-cut overvaluation and a bubble in growth stocks: neither has been seen.

What has not improved and has to be monitored carefully: 1) Our new US EPS growth forecast is just 3.6% for 2017, 9pp below consensus. The main problem for earnings is that wage growth is accelerating (as well as excessive use of one-off factors and overstatement of earnings). 2) Business model risk is the highest we have seen as a result of disruptive technology and China exporting its excess investment. 3) Political risk remains a challenge for equity markets in the form of protectionism, lower immigration and a rise in minimum wages. 4) Buybacks as a style continues to underperform. 5) China housing and the growth in government infrastructure investments seem to have peaked.
The risk near term is that bond yields rise more than the consensus expects (given that financial and economic proxies of cyclicality are improving, net long positions in bonds are extreme, fiscal easing and a trough in JGB yields). We think that equities can accommodate a 50-75bp rise in bond yields. We doubt the Fed would repeat the early Q1 experience of becoming more hawkish as lead indicators fall.

Equity Research – Credit Suisse