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Hold your nerve

Based on our growth and interest-rate forecasts, we remain bullish on stocks, particularly after the most recent correction.

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Editorial

Equities

Hold your nerve

Based on our growth and interest-rate forecasts, we remain bullish on stocks, particularly after the most recent correction.

A little bit more gratitude might have been appropriate. It's true that the March meeting of the Fed didn't offer any spectacular surprises and delivered just what many market observers had expected. Nonetheless, just as in recent years, the Fed provided investors with the stuff market rallies are made of: an economy that runs neither too hot nor too cold – the Goldilocks scenario. And this time Goldilocks got cream on her porridge: a little acceleration in growth without any tangible inflationary pressure. The Fed raised its growth forecasts for the United States from 2.5% to 2.7% for 2018 and from 2.1% to 2.4% for 2019. It kept its forecast for inflation in 2018 at 1.9% and raised it to 2.1% for 2019. Thus everything is fine from an investor's perspective. The risk of overheating seems very small if growth is set to peak this year at 2.7% and cool a little next year. The expected pace of growth is neither too hot nor inflationary but on trend: the U.S. economy has grown by 2.5% on average over the past 25 years.

Yet there was no gratitude, and markets continued their correction. Why? In our view, markets are nervous for a combination of reasons. First, due to their strong performance last year and extraordinary start to 2018, stock markets have reached valuation levels that react very sensitively to any slightly weak data point. An example of this, and therefore the second cause of stock-market nervousness, were the purchasing managers' indices, which in the first quarter remained at a high level but could not push higher, or actually declined, as they did in Europe and Japan. Third, there were growing signs by mid-March that Donald Trump might actually implement his protectionist plans. And fourth, the stimuli from the central banks are widely assumed to abate tangibly this year. Fifth, all of this is happening against the backdrop of rising U.S. interest rates.

This unsettling cocktail ended the unusually long phase of very low stock-market volatility. And the rise in volatility to more normal levels itself affected share valuations negatively by increasing the risk premium demanded by investors. At the same time, it allows active managers to take advantage of market fluctuations with portfolio shifts and adjustments in their cash holdings.

Our positions

We are largely maintaining our cyclical bias, though with some adjustments. From a tactical viewpoint, we have downgraded the materials sector to neutral and upgraded the real-estate sector to neutral. After a long phase of weakness, real estate is trading at a significant discount to the overall market. Investors tend to avoid bond-proxy sectors when interest rates are rising but our interest-rate forecasts are below those of the market. It would take a sharp rise in interest rates to harm stocks in general and high-dividend equities in particular. Although the latter tend to perform worse than cyclical stocks in an environment of rising interest rates, a look at U.S. market history shows that the increase in interest rates had to exceed 200 basis points within one year in order to drive dividend stocks into the red. Therefore we see yields of more than 3.5% on 10-year U.S. government bonds as a critical level. If yields stay below that, stocks should prove resilient. What's more, dividend-payers once again lived up to their defensive nature during the correction in mid-March and may therefore appeal to investors who want to be on the relatively safe side in a more volatile year.

In the materials sector, we are mainly concerned about elevated steel inventories and rising oil production. We continue to view the tech sector positively. Although it further increased its valuation premium by again outperforming the market in the first quarter, this was undermined by operating results. We do, however, recognize that particularly the larger tech companies are facing increasingly stringent and possibly expensive regulatory headwinds. A new stage appears to have been reached, with issues such as data security and privacy rights being discussed even in the United States.

At the same time, the increasingly protectionist rhetoric from the White House could potentially pose a challenge for export-oriented regions and sectors. The first attempts at implementation are already underway and this issue is likely to weigh on markets for some time to come. It is difficult to formulate realistic scenarios of what might happen as Trump's economic rationale cannot be deduced easily – especially as more and more U.S. companies are pointing out that they would rather not have this kind of support from the White House. Due to the lingering uncertainty, we have slightly reduced our index targets for Japan, Europe and Germany. However, given that in some cases these regions – like the emerging markets – enjoy record-high valuation discounts against the United States, we are keeping them at overweight and the United States at underweight. Putting the tech sector aside, these regions have already outperformed the U.S. market this year despite all the turbulence, in which they normally wobble more severely than the United States.

Stocks buoyed by small rate rises in the past

As interest rates usually rise due to increased growth, stocks often rise, too. But the threshold so far is 2 percentage points.

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH as of 3/25/18

* Calculation period between January 1991 and February 2018

** S&P 500 Dividend Aristocrats Price Index

Valuations

Valuations overview

U.S. equities

The effects of the tax reform are already evident in U.S. stock markets, as earnings forecasts and share buybacks rose sharply in the first quarter. However, the market correction in February neutralized the initial market rally and exposed investors' main concern: rising interest rates. Although we don't expect a significant increase in rates in the medium term, we are keeping U.S. equities at underweight due to their high valuation.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH as of 3/30/18

European equities

European equities remain overweight. As an export-oriented region, Europe continues to benefit from the sound global economy. Even the strong euro has had little negative effect so far, and we do not expect the euro to appreciate further in 2018. Other positive factors include a strong domestic economy and increasing investment activity in Europe. European equities should also benefit more than other regions from global reflation.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH as of 3/30/18

Japanese equities

We are also maintaining an overweight on Japanese equities. Besides data from exporting companies being affected surprisingly little by the stronger yen, domestically-oriented companies are showing a high level of confidence. They are benefiting from the upward trend in consumer confidence, partly due to further declines in unemployment. Given further increases in earnings estimates, we do not consider Japanese securities to be overvalued.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH as of 3/30/18

Emerging-market equities

We are keeping emerging-market equities at overweight. Solid global growth and rising inflation are an ideal backdrop, particularly for raw-material-rich countries. We expect profits to grow by 20% this year after an even more impressive 27% in 2017. The reporting season has been very encouraging so far. Should the U.S. dollar appreciate considerably beyond our forecast, however, the market might not perform as well.

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 3/30/18

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