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Equities keep going and going and …

Our 12-month view for equities remains positive as the economy stays on track. Setbacks should be expected.

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Editorial

Equities

Equities keep going and going and …

Our 12-month view for equities remains positive as the economy stays on track. Setbacks should be expected.

Admittedly, it's very tempting to simply reuse last quarter's article for this column. Not because it was particularly brilliant (even if we thought as much, it still wouldn't be right to mention it), but because investors today should be asking themselves precisely the same questions they did in March. That may come as a surprise given the recent political events, particularly in the United States and Europe. But the stock markets reacted to the political developments with such nonchalance and climbed to new records with such ease, that some investors actually started to get nervous. In the first half-year, the S&P 500 Index had moves of more than 1% on only four occasions, and the Stoxx Europe 600 Index on just seven occasions. At such low volatility, isn't it time that even risk-averse investors – for example, the average German retail investor – start warming up to this asset class? Every equity fund manager would welcome such a change in investors' mindset. A newfound love for equities, however, could quickly lose its bloom and see a return to the usual skepticism. We fear that equity indices, particularly those in the United States, have raced somewhat ahead of the facts; that is to say they are behaving in more of a pre-truth rather than a post-truth manner. Therefore, we see a certain risk that U.S. equities may suffer a setback during the summer or fall. Experience tells us that the other indices could also be affected, particularly if a setback turns out to be a stronger correction. The spring of 2016 was the last time we saw how quickly market corrections can develop a negative dynamic all of their own. Especially when you have too many overconfident investors.

There's no arguing that there are several factors right now that speak in favor of equities: global economic growth, in our view, should accelerate this year with central banks remaining in an accommodative mood overall. Furthermore, there are signs that the first quarter's positive reporting season may continue into the second quarter. German companies, in particular, sound pretty euphoric when it comes to their business outlook. Naturally, in such an environment, no one wants to be the first to call the end of the rally, and potentially get it wrong. And what investor would want to exit the market prematurely and leave returns on the table? This is why investors are staying invested, comforting themselves with the notion that, this time, they will surely be able to recognize a deterioration in the indicators and react in time.

Most investors, of course, are well aware that surprises, positive momentum and even economic cycles can't go on forever. Yet, the latter don't die of old age alone. Even though seasoned market players still stare in wonder, the current cycle, as flat as it is, keeps going and going.

Sectors – we prefer growth stocks

The character of this unusual, gracefully aging cycle leads to a composition of preferred sectors that is not typical for any given stage of the cycle: information technology (IT), financials and materials. We believe IT can deliver sales growth even in the absence of strong cyclical tailwinds. Financials on the other hand should benefit from increasing interest rates while still trading at historically low valuations. The latter also applies to the materials sector, especially the sub sector metals and mining, which also profits from stabilizing commodity prices and ongoing stable industrial activity in China. We are less enthusiastic about the other sub sector, chemicals, even though it could benefit from further M&A activity.

In contrast to the health-care sector, the values of the large players in the IT sector have reached such dimensions that M&A activity in this area, amongst the top players, is now unimaginable. The five companies with the highest market capitalization in the world come from this sector, four of which are focused on the internet. The digitization of industrial sectors is in full swing, IT security budgets are growing, and an end to the short product and innovation cycles in consumer IT is nowhere in sight. Compared to the tech bubble of 2000, this sector earns more than adequate margins and is trading at entirely different valuations.

Among value stocks – a term that takes some time getting used to in this context – we have preferred financials for some time. This sector profits from each and every hike in interest rates. At the same time, there are enough banks that have lately strengthened their balance sheets to the extent that we can now look forward to increasing payouts to shareholders. The wave of regulation, which has been a drag on the sector for some time, seems to have peaked.

While we have left our rating unchanged for the three sectors above, we have reduced our rating for the energy sector. We have now returned to a neutral rating after the extended production cuts by OPEC failed to bring about a stabilization in the oil price. We are underweight in the three defensive, interest-rate-sensitive sectors: utilities, telecommunications and real estate.

A trend reversal in the emerging markets (EM)?

EM equities ended their multi-year underperformance versus the S&P 500 Index more than a year ago. We are now expecting a period of outperformance.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 6/26/17

Valuations

Valuations overview

U.S. equities

We expect solid 2017 EPS growth for the S&P 500 Index as U.S. business and consumer sentiment are solid and first-quarter earnings have been strong. Demanding valuations, lowered expectations on U.S. policy and the market's sensitivity to lower oil prices make us move tactically to "underweight" whilst staying "neutral" strategically.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 6/27/17

European equities

Negative news regarding EU disintegration are off the table after Macron won the elections in France. Macro factors are supportive, as is the ECB. Both EPS and top-line growth surprised positively so far this year. We like Germany in particular as business-sentiment indicators are at record highs and stay "overweight."

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 6/27/17

Japanese equities

In the reporting season, firms have issued more benign outlooks than we thought, leading us to upgrade Japan back to neutral. Structural reforms are slowly unfolding and balance sheets look solid. BOJ policy remains a question mark. Political tensions in Korea and the risk of yen appreciation keep us from becoming even more positive.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 6/27/17

Emerging-market equities

Stabilizing macro fundamentals, increasing intra-EM trade, less fear about the Fed and U.S. trade policy and solid EPS recovery – all of these trends are still valid. Reform processes, low inflation figures, particularly in Asia, and expectations for a weaker U.S. dollar confirm our overall "overweight" rating, while we stay cautious on Latam.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 6/27/17

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