Equity markets : Buy the dip

At the end of October and in the run-up to the US mid-term elections, we think it’s a good idea to maintain significant equity exposure. The main reasons for this are:

• with attractive valuation levels relative to all-time averages, the equity markets have entered oversold territory (RSI<30)
• US corporate earnings look set to show steady growth in 2018 (>+20%) and 2019 (>+10%), providing firms with a far higher return on capital than cost of capital, despite the Fed rate hikes
• emerging markets became oversold following the two shocks in April and May. This is particularly true for China, with the fall in the renminbi largely offsetting the higher import tariffs
• potentially positive capital flows to the extent that the level of cash in portfolios is high and where firms are able to redeploy their share purchase programmes after the earnings season

We also think that most of the political risks weighing on the markets since the summer (i.e. the China-US trade war, oil touching $80/barrel, the major risks in Europe over Brexit and the Italian deficit, etc.) have been identified and largely factored in through a record high ‘equity’ risk premium, while the government bond markets have remained relatively immune. Although the correction in February followed a a significant rise in US interest rates, this was not the case in October. Given the earnings growth reported, the most recent rate hike should not be a pretext for jumping the equity ship at current valuation levels.

More than a further positive macro sign, an easing of the political pressures could lead to a rebound on the equity markets, especially after the US mid-term elections. A weaker US dollar would be favourable to both a pick-up in the US markets and the performance of the emerging markets.

In a phase of market recovery, tech, industrial and consumer goods stocks should post better performances, along with commodities.