After a one-week holiday hiatus, Goldman’s David Kostin and crew are back with their weekly “US Kickstart” note in which the bank details conversations they’ve been having with clients.
Unsurprisingly, the hot topic this week was European political risk and, to a lesser extent, the prospects for policy disappointment in the US (amusingly, the prospects for further policy disappointment state-side probably increased on Friday afternoon after Donald Trump once again set an impossibly high bar for Gary Cohn with his “massive” tax cut promise).
For his part, Kostin expects European equities to continue to outperform their US counterparts despite the considerable risk posed by the French elections. There’s also some useful commentary re: earnings season.
Anyone who hasn’t already tuned out for the weekend can find excerpts below.
1Q earnings results have surpassed expectations through the first major reporting week. 19% of S&P 500 has reported results with 55% thus far of firms beating consensus estimates, above the long-term average of 46% (Exhibit 6). Next week is the busiest week of earnings season, with 40% of S&P 500 equity cap reporting. Along with the focus on earnings, client conversations have been focused on near-term political risks:
(1) The first round of the 2017 French presidential election will occur on Sunday, April 23. Recent opinion polls have indicated a closer race than originally expected. If no candidate has an absolute majority, a run-off between the top two candidates will be held on May 7 with the winner assuming the presidency by May 14. Many investors have ignored France’s semi-presidential system, where the 577-seat National Assembly will be determined in a two-round election on June 11 and June 18. “Cohabitation” is possible if the President and Prime Minister come from different parties.
(2) Congress must pass a spending bill before April 29 in order to avoid a government shutdown. The temporary continuing resolution in place granting government spending authority expires on April 28. According to our Washington D.C. economist Alec Phillips, the risk of a shutdown at the end of next week is low (~25%), but rises if the debate extends to May. The greater risk of a shutdown appears more likely in October, when the debt limit will be reached around the same time as the start of the 2018 fiscal year.
Although US realized volatility is historically low, implied volatility has typically jumped in the final days before political events. Despite heightened uncertainty, S&P 500 3-month realized volatility ranks in just the 2nd percentile of the past 30 years. During the lead-up to the Brexit vote and the US election, investors began hedging only during the final 2-3 weeks before the vote. The same pattern has repeated this month (Ex. 1). 1-month European implied volatility has spiked from 17 to 25 since the start of April. Despite the recent pickup in European volatility, European equities have recently outperformed US stocks. S&P 500 has lagged STOXX 600 by 300 bp since Election Day last November (11% vs. 14%). Flows into European equity funds have steadily increased post-Brexit, totaling $5 bn YTD vs. $99 bn of outflows in 2016. Growing skepticism regarding the likelihood of fiscal stimulus in the US has weighed on the S&P 500.
Despite initially signaling that the delay in health care reform would accelerate a transition to tax reform, President Trump has recently indicated that health care reform will once again be the top priority, and our D.C. economist sees a high likelihood that the enactment of tax legislation will be delayed until 2018.
Strong global growth, faster earnings growth, and lower valuations should help European equities continue to outperform US stocks in 2017. European equities are more levered to global economic growth than US stocks. Our global Current Activity Indicator stands at 4.4%. Our European Strategy team forecasts STOXX 600 will grow earnings by 15% in 2017 versus our forecast for 9% S&P 500 EPS growth. Europe is also earlier in the cycle than the US, supporting the case for greater expansion in margins and earnings. The S&P 500 trades in the 88th percentile of historical valuation, versus the 64th percentile for the STOXX 600 (18x vs. 15x on P/E alone). Our Europe strategists expect STOXX 600 to rise to 390 (+3%) during the next 12 months, while we forecast S&P 500 will fall by 1% to 2325.
Investor preference for European exposure has also translated into the outperformance of US companies with a high proportion of sales in Europe. Since Election Day, our basket of 50 Russell 1000 stocks with the highest sales exposure to Europe (ticker: GSTHWEUR) has outpaced S&P 500 by 300 bp (14% vs. 11%) as economic data improved, despite a stronger USD and potential risks to trade. See Exhibit 5 for a list of constituents.
The outperformance of Europe-facing US stocks vs. S&P 500 has likely run its course. Our GSTHWEUR basket benefited from the acceleration in global economic growth, which is likely behind us (Exhibit 4). Our US economists estimate that global GDP growth equaled 4.1% in 1Q, but that global growth will average 3.7% during the remainder of 2017. Furthermore, despite the benefits to these stocks from their leverage to European growth, they still bear the extended valuations carried by most S&P 500 companies. The GSTHWEUR basket trades at 20x forward P/E vs. 18x for the S&P 500.
The outlook for US firms with the highest domestic sales exposure is less favorable than we had expected post-election. We had previously recommended buying firms with high US sales (GSTHAINT) vs. firms with high international sales exposure (GSTHINTL) based on the prospects for a stronger USD, improving US economic growth, and the risks of protectionist trade policies. However, our FX strategists recently reduced their expected trajectory of the trade-weighted US dollar given strong global growth, rhetoric from the Trump Administration, and a cautious Fed. In addition, although domestic-facing firms are relatively insulated from trade and geopolitical risks, our Washington D.C. economist notes that the administration has changed course on trade policy and we do not expect major changes in the near-term amid heightened geopolitical uncertainty.