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Political stock markets

Sure, there are other options. Still, equities may remain a sound investment in politically challenging times. You just have to look beyond the level of headline indices.

Political risk is currently playing a leading role in investment decisions. The Brexit vote is yet another example of equities suffering less lasting damage from political upheaval than other asset classes. Currency and bond-price reactions were much more sustained than those of equity indices, which quickly recovered. But the vote is likely to shape Europe for years to come. It is too early to tell whether the outcome of the referendum will strengthen or weaken the cohesion of the European Union (EU). Although political stock markets tend to be proverbially short-lived, cyclical investment decisions are also ultimately based on sentiment.
Initially, we expect to see cyclical improvements, which should ultimately translate into higher U.S. earnings. In both Europe and Japan, the business environment generally looks better than the political environment.

For many stock-market indices, however, we see little upside potential in the next twelve months. A look at the past is also sobering: none of the major stock markets have managed to reach their 2000 or 2007 highs in U.S.-dollar terms. Of course, there is one exception: the U.S. market. By contrast, the MSCI AC World ex U.S. Index trades around one-quarter below its 2007 high. Admittedly, the United States benefits from its flexibility, high returns on equity and successful technology companies. U.S. shares could also potentially profit from their perceived status as a less risky investment destination . Lingering investor concerns are, after all, reflected in the high cash positions held by institutional investors – at levels not seen since 2001. Still, it pays to take a closer look at another source of strength for the U.S. market.

Who is buying U.S. equities?

Thanks to the European Central Bank (ECB), U.S. companies are buying more of their own shares. This may sound strange at first, but it is closer to the truth than one might think. The ECB’s low-interest-rate policy has already put downward pressure on U.S. interest rates. With the ECB’s extension of quantitative easing, U.S. companies now have a more direct route toward benefitting from cheaper refinancing across the pond. That is because the ECB can, in principle, purchase euro-denominated bonds from the subsidiaries of U.S. companies registered in the Eurozone. The willingness to take advantage of this type of subsidized financing is demonstrated by the fact that companies whose bonds fit into the ECB's purchasing scheme are having an unusually high volume of issuance. Raising funds is not dictated by need but by availability and price. And what are companies doing with all the money raised? In the United States, they are choosing to buy either their own shares or interests in other companies.

Between 2013 and 2015, S&P 500 Index companies spent 21% more on dividends and share buybacks and 156% more on cash acquisitions. Investment spending on fixed assets grew by only 2%. This may suggest a lack of courage by many companies, who may instead be opting to use shortcuts to boost their growth and earnings per share. Low interest rates make all this possible. That is what has kept interest payments virtually flat for the past four years despite a sharp rise in net debt. Gross debt as a percentage of gross domestic product (GDP) for U.S. non-financial companies has already returned to record levels. A cause for panic?

Well, rising interest rates and falling profits could pose an immediate threat to highly indebted companies. However, we see little room for an increase in interest rates and believe profits should rise again in 2016 and 2017. This suggests that U.S. corporate-debt levels may start to pose a risk in the medium term, but not immediately.

" The stock market may see fresh momentum from fading political worries and positive earnings surprises in the second half-year. "

Henning Gebhardt, Global Head of Equities

Companies tower over U.S. equity markets

The extent to which companies are the dominant buyer of equities is quite remarkable. Is this a sign of confidence – or merely of the lack of other options?

Sources: Goldman Sachs Global Investment Research, FactSet Research Systems Inc.; as of 7/22/16

Equities: Valuations

Equities USA

We expect modest earnings-per-share (EPS) growth in 2017. Near-term, EPS acceleration in the second half of 2016, solid macro trends and uncertainty in Europe could cause the S&P 500 Index to overshoot our index target as it is seen as a less risky investment. This might continue to further support defensive dividend payers in particular.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 7/21/16

Equities Europe

Near-term Brexit-related concerns and financial-sector challenges are likely to keep a lid on European equities. Europe’s valuation discount compared to the U.S. looks set to remain at elevated levels. We have cut our earnings forecasts to reflect less growth and the impact of lower interest rates for financials.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 7/21/16

Equities Japan

The strong yen is a stumbling block for Japanese equities, as is the domestic economic backdrop. However, many Japanese firms have strong earnings and solid balance sheets. We remain optimistic on corporate-governance reforms. On top of appealing valuations, this leads us to take a more positive view on export-oriented companies.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 7/21/16

Equities emerging markets

Emerging markets are benefiting from the U.S. Federal Reserve’s hike delay, commodity-price stabilization and little exposure to Brexit-related concerns. While earnings should recover in 2017, we see downside risk to 2016 numbers. Latin American earnings could, however, surprise, helped by commodity prices and a recovery from cyclically depressed levels in Brazil.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 7/21/16Source

Forecasts in times of volatile markets1

Our index forecasts suggest little upside potential. This does not mean, however, that equities cannot play a strategic role.

Oddly enough, our CIO Days almost always take place in times of strong market volatility. This means from the time price targets are set until their publication, there can be considerable changes to upside potential. On this quarter’s CIO Day, several markets appeared to continue to have some upside potential. But, the recovery rally that followed quickly made virtually all indices look overvalued.

With respect to our forecasts: We believe giving a precise twelve-month forecast would be futile, with markets likely to bounce between overshooting and undershooting our targets. This would not be a cause for immediate action. Exaggerations are customary in capital markets; momentum is a force that should not be underestimated. The movements we believe are more important are those taking place outside the indices in sectors and at individual-stock levels. Setting price targets prompts us to challenge our assessments.

Currently, we see little upside potential. If markets rally further, trimming positions might be worth considering, unless, of course, our earnings estimates – which are below consensus – prove too conservative in the meantime.

F refers to our forecasts as of 7/7/16.

Equities

  Equity markets (index value in points) Current2 June 2017F Total Return (expected)3

Forecast

in %

Expected earnings growth in %

P/E impact in %

Dividend yield in %

United States (S&P 500 Index)

2,169

2,100

-1.0

4

-7

2.2

Europe (Stoxx Europe 600 Index)

341

330

0.2

4

-8

3.5

Eurozone (Euro Stoxx 50 Index)

2,979

2,900

1.3

2

-4

3.9

Germany (Dax)4

10,248

10,300

0.5

-1

-2

3.2

United Kingdom (FTSE 100 Index)

6,724

6,200

-4.3

7

-13

3.4

Switzerland (Swiss Market Index)

8,227

8,150

2.4

4

-4

3.4

Japan (MSCI Japan Index)

785

800

4.2

-1

3

2.3

MSCI Emerging Markets Index (USD)

871

830

-2.2

3

-4

2.4

MSCI AC Asia ex Japan Index (USD)

528

500

-3.0

1

-3

2.4

MSCI EM Latin America Index (USD)

2,360

2,100

-8.8

18

-24

2.2

ref-1

1Source: Deutsche Asset Management Investment GmbH; as of 7/26/16

ref-2

2Source: Bloomberg Finance L.P.; as of 7/26/16

ref-3

3Expected total return includes interest, dividends and capital gains where applicable

ref-4

4Total-return index (includes dividends)

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