Outlook for equities in 2017

Who'd be a tipster? It's hard enough in more predictable times, but it seems every week holds a new set of challenges for financial markets. Certainly, the team at UBS isn't relishing the demands of clients for predictions in the final four weeks of 2016, let alone where the FTSE 100 will finish in 13½ months.

Next year, Donald Trump gets the keys to the White House, Theresa May will likely kickstart Britain's exit from the EU, and a series of hugely significant elections could spell the end of the single market.

But before we get to 2017, we've got the Italian referendum on 4 December and a re-run of Austrian presidential elections on the same day. Then there's the European Central Bank meeting on 8 December, when quantitative easing will be on the agenda, and a very likely Fed interest rate hike on the 14th.

However, UBS is optimistic on European equities. "We believe 2017 is a window of opportunity, but a narrowing one: by 2018 we see the eurozone slowing to 1.2% GDP growth and the UK 0.7%," it says.

"We think consensus estimates of 13% earnings per share (EPS) growth for 2017 are too high, but still expect 8% - the first growth for six years. This would be a big deal for European equities and allow some rehabilitation amongst investors."

Reversal of fortunes

UBS gets its growth forecasts by predicting that three major drags on markets - commodities, zero inflation and emerging markets - will reverse. That's based on a decent third-quarter reporting season and revenue momentum which just turned positive for the first time in 16 months.

This should allow a total return of about 10% - a 7% rally for the Stoxx 600 to 360, plus forward dividend yield of 3.8%.

For investors to 'trust' cyclically adjusted earnings they need to see actual earnings turn firstMarkets have already done very well since the Brexit vote, and again since Trump. But UBS still reckons European equities trade at a 20% discount to the average cyclically adjusted price/earnings (PE) ratio - today's price divided by the average of the last 10 years trailing earnings.

"The difficulty is that for investors to 'trust' the cyclically-adjusted earnings they need to see actual earnings turn first - six years of no growth has left them understandably sceptical," it says.

"Much of the recovery has been driven by multiple expansion. But in the last two years the market has been trading in a range from 13x to 16.5x (at the peak in April 2015).

"Currently the market is only 2% below the long run average but…this is on particularly depressed earnings."

The year ahead

But what does this mean for UK equities over the next 12 months or so?

"We struggle somewhat with the valuations on the UK market," admits UBS, which points out that the forward PE is "up with events", trading in line with the long-term average at over 15 times.

Yes, there's perhaps further benefit from sterling weakness, with 75% of the FTSE revenues coming from outside the UK. "But even allowing for further weakness in sterling and higher oil prices, our top-down earnings model suggests that much of that is now already in the price on the consensus EPS estimates of 18% growth in 2017," writes the broker.

UBS has decided on a FTSE 100 target of 7,100 for the end of 2017, but is cautious here.

In euro terms the index is leading down around 4% since the Brexit vote, and by 8% in dollar terms. "At some point overseas investors are going to be more concerned about the losses from Sterling weakness than the gains in local currency for the FTSE," it says. "Maybe we are close to that tipping point now."

We may move from monetary to fiscal policy boosts - CRH and BAE Systems are potential beneficiaries"Additionally, we would argue that 25% of the revenues are domestically exposed, where we have yet to see the economic slowdown hit and have only had the 'front-loaded' good news from policy etc.

"Our economists expect the UK to slow to just 1.0% growth in 2017 and 0.7% in 2018."

In terms of sectors, the broker upgrades energy plays to 'overweight' from 'neutral' as the oil price drag on profits becomes a boost and the sector offers the highest dividend yield in Europe. Earnings should turn positive soon, so "plenty more upside from here".

However, there are a few factors which could improve chances of success next year.

Governments could switch from monetary to fiscal policy boosts - CRH and BAE Systems are potential beneficiaries - companies could exploit ultra-low bond yields and re-leverage, and a final "stretch for yield" could see a PE re-rating to "bond-like" levels.

"Finally, there is the risk US investors, the key swing investors for European equities come back in 2017 after 10 months in row of selling European equities."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.