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When boring is the best outcome

Extremely low or negative interest rates challenge our assessment of equity as well as fixed-income markets. But this is not the time to increase valuation multiples.

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Editorial

Equities continue to like it soft

Having entered its eighth year, this prolonged equity bull market has to justify its existence more than ever. High levels of increased political uncertainty, lackluster earnings growth and continuous low inflation make this even more important. In this context, equity valuation remains at the center of the debate. With nominal 10-year sovereign rates likely to stay oscillating around zero for some time yet, traditional equity valuation models may have reached their limits. Even in “normal” times, rates have a contradictory impact on equity valuation, as they both impact valuation and growth outlook. On the one hand, long-term nominal interest rates move very much in sync with nominal gross-domestic-product (GDP) growth and/or growth expectations. With 10-year U.S. Treasuries trading at 1.6% that may not bode well for future GDP growth and corporate earnings. On the other hand, these rates are the benchmark that risky assets are valued against and that discount models rely on. If the alternative asset returns less and future earnings are discounted at lower rates that should increase equity valuations.

But what if nominal rates are so low that they might not express cyclical swings but structural concerns about growth potential? This would clearly weigh on valuations. And what if long-term rates have lost their ability to signal future growth and earnings trends, because they are so heavily influenced by central banks? Does this leave the door open to still hope for higher growth rates? We rather see hyperactive central banks as another reason for concern in the mid to long term. Talking about structural concerns: equities remain a risky asset class likely to be avoided in unsecure times. With bonds worth more than $20 trillion globally now having negative yields, fixed income might not be the best consideration in this environment.

Multiples – don’t get carried away

How does all this translate into our equity valuations? We believe that for the time being central-bank policy action offers a degree of downward protection for almost all asset classes. And in case of real stress, equities could in fact be less affected than fixed income. However, we refrain from reducing equity risk premia and, as a result, increasing target multiples. First, because we share the view that structural changes cannot be ignored – most obviously, reduced productivity growth. And lower earnings-per-share growth rates warrant lower multiples. Second, because we also expect lower multiples for U.S. equities as a result of the tightening rate cycle, in line with historic patterns. From our perspective, continued low economic growth, combined with a stable oil-price outlook, essentially static long-term interest rates and a very cautious U.S. Federal Reserve (Fed) might remain the best scenario for equities. In this environment dividends would be the main source of the lower single-digit returns we expect. Given that valuations have already reached relatively high levels, risky assets would not be helped by either an economic acceleration or a deceleration. The first scenario could be too “hot”: rising interest rates would probably lower valuations, in particular for “bond-proxy” stocks. The second could be too “cold”: equity markets would be hit by declining earnings.

" What I like about EM equities is the fact that this is the only region currently that shows significant positive earnings-estimate revisions. "

Henning Gebhardt, Global Head of Equities

Low and slow is still what equities like most

Too strong a recovery triggers higher interest rates, hurting valuation multiples. On the other hand, too little growth hurts earnings.

Source: Deutsche Asset Management Investment GmbH; as of 09/2016

Valuations

Equities United States

We are neutral on the U.S.: recent economic data has been mixed, but monetary policy should remain expansionary despite moderate rate hikes. Expected earnings-per-share (EPS) growth of 6% for the next twelve months should be offset by an expected decrease in the price-to-earnings (P/E) ratio of 5% for the S&P 500 Index, while we expect a dividend yield of 2.2%.

Equities USA

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 9/28/16

Equities Europe

We expect the valuation spread between European and U.S. equities to remain at an elevated level, given the uncertainties in the European financial sector, upcoming elections and the unclear implications of Brexit. However, we have recently seen earnings revisions turning slightly positive in Europe.

Equities Europe

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 9/28/16

Equities Japan

We are sticking to our overweight on Japan given long-term corporate-governance improvements. We however find it difficult to predict the implications of the next Japanese policy move and would rather focus on company fundamentals, which remain solid in our view. Strong balance sheets should more than offset the effects of weaker growth.

Equities Japan

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 9/28/2016

Equities Emerging markets

In emerging markets we see clear signs of macro stabilization and a cyclical recovery, some of which is commodity-price driven, prompting us to raise earnings estimates – in Latin America’s case to above consensus. We remain neutral overall, as the market has already strongly rebounded, but are positive on single countries.

Equities emerging markets

P/E ratios based on consensus estimates for NTM (next twelve months) earnings. Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 9/28/2016

Forecasts

No marked regional preferences

F refers to our forecasts as of 9/22/16.

Earnings growth is low in most regions, while valuations are not. This leaves little upside potential. Dividends still rule.

Equities

  Equity markets (index value in points) Current* Sep 2017F Total Return (exp.)**

Forecast

%

Expected earnings growth (%)

P/E impact (%)

Dividend yield in %

United States (S&P 500 Index)

2,160

2,190

3.6

6

-4

2.2

Europe (Stoxx Europe 600 Index)

341

340

3.4

5

-6

3.5

Eurozone (Euro Stoxx 50 Index)

2,971

3,050

6.6

4

-2

4.0

Germany (Dax)1

10,361

10,700

3.3

1

-1

3.2

United Kingdom (FTSE 100 Index)

6,808

6,400

-2.6

11

-15

3.4

Switzerland (Swiss Market Index)

8,175

8,250

4.3

6

-5

3.4

Japan (MSCI Japan Index)

812

820

3.5

1

0

2.3

MSCI Emerging Markets Index (USD)

911

920

3.5

7

-3

2.4

MSCI AC Asia ex Japan Index (USD)

557

560

3.1

7

-3

2.4

MSCI EM Latin America Index (USD)

2,383

2,400

3.7

22

-17

3.0

We are not changing our central equity-market scenario: global equities are in a mature market phase. We expect a continuation of the volatile sideward trend with markets temporarily overshooting and undershooting our index targets. In the end, investors should be able to capture at least dividends, which are still attractive in this low-yielding world.

Sector-wise, we confirm our tactical underweight in consumer staples. The sector is expensive and appears “over-owned”. At a fundamental level, many companies in the sector are suffering from low food-price inflation. We will review our tactical consumer-discretionary overweight next month as we notice growth concerns in areas like the automotive industry and luxury goods.

Analyzing the two popular equity styles of “value” vs. “growth”, we notice that in the past 10 years “value” gains have predominantly reflected the combined performance of energy and financials vs. the rest of the market. Put differently: a rising oil price and Fed fund rate are probably required for “value” stocks to outperform the market.

ref-1

* Source: Bloomberg Finance L.P., FactSet Research Systems Inc.; as of 9/27/16

ref-2

** Expected total return includes interest, dividends and capital gains where applicable

ref-3

1 Total-return index (includes dividends)

ref-4

Source: Deutsche Asset Management Investment GmbH; as of 10/7/16

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