2H 2017 Investment Outlook: How To Position Your Portfolio For The Year Ahead!

It has been a fruitful first half in 2017 as both equity and bond markets on aggregate posted positive returns year-to-date. Global equity markets (represented by the MSCI AC World Index) posted a 10.3% return, while global fixed income markets (represented by the JPMorgan Global Aggregate Bond Index) delivered returns of 4.2% over the period.

Breaking down the equity markets regionally, we saw that the developed markets, while posting positive gains year-to-date, have generally lagged behind emerging markets. The US equity market (represented by the S&P 500 Index) emerged the better performer in the developed markets space, registering an 8.3% increase in the first half. Over in emerging markets, Asian countries, including Korea, India, Hong Kong and China, led the pack. Among the markets under our coverage, China H (represented by the MSCI China Index) and Asia (represented by the MSCI Asia ex-Japan Index) were some of the strongest performers, delivering 24.5% and 21.6% returns respectively during the period.

In the fourth quarter of last year, we reckoned 2017 to be a "year of inflexion" as we had expected global markets, especially those of emerging economies, to have bottomed out and for earnings growth to turn positive. We have also predicted upward re-ratings in valuations for both Asia and emerging markets as the earnings cycle turns positive. As we approach 2H 2017, here's a quick review of the market calls we made last year, most of which have turned out right so far, and how investors should position themselves for the rest of the year ahead.

[All returns in local currency terms as of end-June 2017]

Quick Review: Market Calls Made in 4Q 2016

MSCI Emerging Markets Index (+16.4%); MSCI Asia ex-Japan Index (+20.9%)

• We were at the inflexion point for earnings upgrades and re-rating of valuations.
• Since peaking in 2011, earnings of emerging markets have suffered from a five-year downgrade until June 2016, when we started to see upward revisions in earnings forecasts.
• Emerging markets had underperformed developed markets by around 40% since its post-2008 global financial crisis peak in May 2011. The situation reversed as we saw more upward earnings revisions in emerging markets compared to developed markets since June 2016.
• We were bullish on the upward re-rating potential of Asia and emerging markets that would lead to superior performance over the next two years.

MSCI China Index (+23.9%); Hang Seng Index (+16.3%)

• China's economic recovery was in sight.
• After contracting for 55 consecutive months, China's producer price index (PPI) deflation was expected to come to an end in 2016. It was a positive for corporate earnings, especially for companies in upstream sectors.
• The industrial destocking cycle this time around lasted for 22 months and was likely to take a turn for the better moving forward. With the economy starting to pick up steam and inflation expectations back on the radar, we had expected a restocking cycle to begin.
• The upward earnings revision cycle might have just begun and it was reasonable to expect more earnings upgrades in Chinese stocks moving forward.
• We believe that the equity markets of Hong Kong and China will see valuation re-ratings in the coming 1 – 2 years.

Limited Room For Further Valuation Re-rating For Some Markets In 2H 17

Table 1: Market Performance, Valuations And Earnings Revision

• Market performance can be broken down into the contributions from valuation multiple expansion and earnings growth.
• As shown in Table 1, most of the major markets' year-to-date performances have been driven by an expansion in valuation multiples, with India, Hong Kong, China and Indonesia among those receiving the largest re-rating while Russia, Brazil and Latin America suffering from multiple contractions.
• Some markets have risen on the back of strong earnings upgrades. Asia, emerging markets, Brazil, Korea and Singapore had the biggest upgrades in 2017 estimated EPS year-to-date (Table 1). However, earnings downgrades were seen in seven of the markets above including US and Europe, while revisions for the rest were not significant; earnings upgrades across the board were not as large as what we saw in valuation expansion.
• Given the magnitude of the rally year-to-date, driven mainly by the upward re-rating in valuation multiples, it will be difficult for the valuation multiples of certain markets to expand further given their already stretched valuations.
• Two major regional markets that we believe will face such a particular scenario are the US and Europe equity markets, which apart from seeing rather stretched valuations, are also facing monetary policy normalisation and an end to further easing measures respectively, eventually resulting in reduced liquidity down the road.

Earnings Growth The Key Determinant For Market Performance in 2H

Table 2: Forecasted EPS Growth and PE Ratio

• As room for further re-rating in valuation multiples are increasingly limited, earnings are expected to be the key determinant of market performance in the second half. As of end-June 2017, almost all of the markets under our coverage are expected to record robust earnings growth in the coming two years.
• Sorted by 2017 EPS growth, Brazil tops 2017E EPS growth at 35.3%, followed by Korea (30.6%), emerging markets (26.6%) and Asia (23.4%). 12 out of 18 markets above are expected to record double-digit earnings growth this year.
• With the exception of US, Europe and select ASEAN markets, we are not yet at materially elevated valuation levels. Robust earnings growth in the coming years will help to push valuations back to an even cheaper level whilst driving market indices higher.

More Earnings Upgrades to Come after 1H Earnings Announcement

Chart 1: Global GDP Growth And Corporate Profits

• In 1H 2017, Asia and emerging markets have received the largest earnings upgrades. As of end-June 2017, Asia ex-Japan (represented by the MSCI Asia ex-Japan Index) saw a 7th consecutive month of earnings upgrades. It was the third time since 2001 that we saw a string of upgrades (the other two were in 2004 and 2009), thanks largely to Korea, which saw its current estimated earnings upgraded by more than 14%! China H and Hong Kong also saw upward revisions of 5.8% and 5.4% respectively, while the rest of the Asian markets only received modest revisions.
• We believe there is still room for further upgrades in the current cycle. Historically, world nominal GDP growth has a high correlation with the earnings growth of global equities (represented by the MSCI AC World Index). As global economies are recovering and the world's nominal GDP growth is accelerating, 1H earnings have generally surprised to the upside. More earnings upgrades can be expected especially after the release of strong earnings data following the interim earnings season.
• The same pattern can also be observed in China A and H non-financial stocks, as indicated by the high correlation between their revenue growth and nominal GDP growth, as well as the correlation between profit margins and PPI. The estimated earnings H-shares (represented by the HSML100 Index) in 2017 have been revised up by 2.1%, while A-shares (represented by the CSI300 Index) have been downgraded by -3.1%. In view of a firmer economic backdrop for China, we expect some upgrades to come especially after beating 1H earnings expectations.

North Asia To See Another Wave of Earnings Upgrade In 2H

Chart 2: Global Semiconductor Sales (3-Month Average)

Chart 3: Korea's Earnings Trend

Chart 4: Taiwan's Earnings Trend

• On a year-to-date basis, Taiwan, South Korea and Japan have all received upgrades to their estimated earnings, with South Korea equities leading the pack with a 14% upward revision.
• The global semiconductor sector is pro-cyclical, with sales tending to overshoot on both the upside and downside. Chip sales have started to recover since the third quarter of last year and the recovery is expected to gain further momentum as manufacturers tend to time the cycle by ramping up production when future demand is expected to be strong. The World Semiconductor Trade Statistic has estimated semiconductor sales growth to be 11.5% by end-2017. We think further upside can be achieved and these figures are expected to point to further positive earnings results of relevant markets for 2Q and 3Q 2017.
• Most of Taiwan and South Korea's earnings upgrade have come from the upward revision in the outlook for the semiconductor business, with related companies' 1Q earnings mostly beating market estimates.

Chart 5: TSMC Estimated Earnings

• On Taiwan's side, 2Q has been a hard time for TSMC because of inventory adjustment from Chinese customers, a trend that analysts believed would end in 3Q, while the company is confident of bringing back positive growth in earnings from 3Q. Market seems to be bit too conservative in their 2H earnings estimation, leading to relatively low earnings forecast for the company and even the whole Taiwan market (Chart 5).
• As major Chinese mobile phone manufacturers released their popular models in June and the iPhone cycle starts to feed into related companies' earnings in 3Q, it is possible for Taiwan and South Korean equities to see further earnings upgrade in the second half, while expectations are low for Japanese equities to receive another wave of earnings upgrade within the period.

What Should Investors Do?

• We believe that it still remains appropriate for investors to remain overweight equities vis-à-vis bonds at this juncture, after considering where we are in the current economic cycle, market valuations, as well as monetary policy at this juncture and what lies ahead in the future.
• However, we advise investors to reduce the equities overweight in their asset allocation. From a previous +10% overweight in equities vis-à-vis bonds at the start of the year, we think investors could look to reduce this overweight to a +5% given the expectations of lower returns from equities moving forward as equity valuations have broadly risen across the board thus far in 2017.
• We continue to prefer the faster growing but yet, more attractively valued regions of Asia ex-Japan and emerging markets. Both regions continue to trade at a discount to their estimated fair PE ratios, indicating that they continue to remain undervalued despite having turned in a sterling performance in 1H 2017.
• Although we do not think the bull market is over at this juncture, investors are advised to be more selective with where they allocate their capital to, as well as the products that they utilise. Active management will be increasingly important as valuations head higher and the need to separate the wheat from the chaff becomes greater.
• While we have not expounded on bonds in this article, we continue to remain defensively positioned across all fixed income segments given that yields have continued to remain at unattractive levels. In certain segments, such as US high yield and emerging market bonds, we've also seen both yields and spreads head lower, making them even less appealing to us at this juncture. With low yields contributing to interest rate risk, and the threat of an end to an era of ultra-easy monetary policy lurking in the background, a defensive position in fixed income is warranted in our opinion.

The Research Team is part of iFAST Financial Pte Ltd.