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Uncomfortably constructive

The tenacious rally is being eyed skeptically, including by us. For now, however, we see few signals of it ending.

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Editorial

Equities

Uncomfortably constructive

The tenacious rally is being eyed skeptically, including by us. For now, however, we see few signals of it ending.

Many people expect and − in some cases − even long for a market correction, if only to be able to talk about market-entry points with greater conviction again. Of course, a fall in equity markets might also give them – and indeed us – a better story to tell. However, pessimists are seriously tempting fate. We readily admit that we expected to see a setback this summer. Instead, even the traditionally susceptible month of September proved to be harmless. In capital-market jargon, harmlessness translates into a "period of low volatility." In this case, the period is lasting a long time. Many asset classes are recording new lows in volatility. For the S&P 500, eight out of nine months this year have ranked among the 20 least volatile months since 1997, despite hurricanes and President Trump's tweets. In the United Kingdom, which faces an equally turbulent political landscape, the FTSE 100 has remained in a range of around just 6 percent this year − a first in the history of the index dating back to 1984.

Inertia instead of euphoria

Low volatility and rising share prices should usually cheer up shareholders, but there is little evidence of this. Instead, trading volumes rather reflect apathy. The volume of MSCI World equities traded in the third quarter of 2017 has been lower than in any other quarter since early 2002, despite strong growth in trading volumes by high-frequency traders. This makes long-term investors appear even more passive. No one seems to really trust in this rally, now nearly nine years old. Market players are finding a lot to criticize, even the low level of volatility. Some analysts believe this represents risky complacency by investors, while others see it as a reflection of the ongoing boom. The ambivalent opinions on the state of the market continue.

Some think that the boom is being driven too much by just a handful of technology stocks, while others regard this as a justification for the strong run of U.S. equities. One faction criticizes the synchronization of risk assets as a result of central-bank actions, while another celebrates 2017 as a year when stock picking is beginning to pay off again. Some are bothered by how dependent many Western listed companies are on China's economy, while others are thrilled by the strong demand from emerging markets. Some think that equities are too cheap, while others…. No, actually, you are unlikely to find investors who think that equities are too cheap.

Is skepticism warranted?

What are the reasons for skepticism among many investors? It might be a combination of experience and lack of experience. Most investors who lived through the market corrections in 2000 and 2008 know a thing or two about bad experiences, and there certainly are parallels between today and 1999 or 2007. There are differences too, however. This takes us to the second key issue: we are in uncharted territory. Chief among the unknown factors are the major central banks' bloated balance sheets and the question of what may happen once they begin reducing their securities exposures. Closely related to this is the potential impact the end of the pervasive low-interest-rate environment will have, notably on the heavily indebted corporate sector.

On top of all these considerations, the current boom has some unusual features, such as weak productivity growth, anemic inflation, and last but not least its sheer longevity. In a few months, it will become the second-longest bull market in U.S. history # . But change is not limited to the macro level; it can be seen at the micro level as well. Just look at the biggest winners and losers among S&P 500 companies in terms of market-capitalization changes during the first three quarters of 2017: The four most successful companies are all internet businesses, and collectively saw their market capitalization grow by $500bn. The same market value was, however, at the bottom lost by some 50 companies, among them icons of "traditional" industries, as well as telecommunication companies and computer manufacturers. This underscores the radical market division, which has also emerged at a global level. The ten most valuable companies # primarily operate in the internet and software sectors, and two hail from China. While only founded 19 years ago, their current market capitalization of $850bn equals one fifth of the capitalization of the entire Shanghai A-Share Index.

Our equity strategy

How are these observations reflected in our equity strategy? For one thing, we think that the period of low volatility could persist, especially as no immediate triggers of a lasting market correction are in sight. We continue to expect further rises in corporate earnings and increase our share-price targets accordingly. Among businesses, we expect the digitalization to continue to challenge some and benefit others. We are leaving our valuation multiples # virtually untouched, because we do not anticipate that economic cycles will disappear. It remains to be seen how well the current economic and financial system can withstand the next downturn.

A digital year: technology stocks in a special cycle

Over the past year, the global technology sector, dominated by internet giants, has left the overall market behind, including brick-and-mortar retail.

Valuations

Valuations overview

U.S. equities

Even if U.S. stock markets have benefited from the strength of internet giants this year, we see earnings growth spread out across many sectors in our twelve-month forecast. Despite the disappointment with the U.S. President's legislation attempts to date, we believe that tax cuts modestly advantageous to companies could still be passed in the coming months. However, the market is becoming increasingly prone to disappointments.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 10/4/17

European equities

Europe's economy continues to benefit from the good global economy. Sentiment indicators remain strong, and France's President Macron is making further progress with economic reforms. We believe the euro's upward swing is over for now, which might provide a tailwind for equities, as could the valuation discount versus U.S. equities, which has recently grown again. Rising dividend payout ratios and a flurry of acquisitions should help, too.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 10/4/17

Japanese equities

Japanese companies also continue to surprise with good figures. As we expected, their spring forecasts now already prove to have been too conservative. Among industrialized countries, Japan is leading the way in terms of earnings revisions. Despite this rosy picture, we currently see little that would rekindle the interest of foreign investors, who may be concerned by the tensions with North Korea and a weaker dollar.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 10/4/17

Emerging-market equities

Emerging markets are still a source of optimism. Risks from the United States have not materialized as feared: Interest rates are increasing only modestly, the dollar has been weaker than expected and Trump has not imposed trade restrictions yet. Earnings growth is sound, inflation is historically low and valuations vis-à-vis industrialized countries are appealing. With its successful tech firms, Asia remains a compelling region.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 10/4/17

ref-1

According to the definition of the National Bureau of Economic Research

ref-2

As measured by the stock-market value of companies included in the S&P Global LargeCap

ref-3

In the form of our target multiples for the indices' price-to-earnings ratio

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