US equities can benefit from the end of QE and post an annualised return of 10% by end-2014, according to AXA IM head of research Eric Chaney.
Analysing the impact of a tapering of the Federal Reserve's quantitative easing programme, Chaney and team said asset prices will most likely return to their "fundamental dynamic equilibrium" as the first stage of normalisation begins.
Assuming tapering begins this September, the wind-down will be complete by mid-2014, according to the team. Below we detail their predictions for how this process will affect a number of asset classes.
End of QE: expected impact on asset prices (end-2014, baseline/alternative growth scenarios, year-end US inflation at 1.8%)
US GDP 2014 Q4/Q4
|10Y treasury yield||US IG credit spread||EM IG hard currency spread||US equities annualised rtn||Euro equities annualised rtn||EM equities annualised rtn|
Baseline GDP: 2.5%
Alternative GDP: 3%
QE3 has inflated US equities to the extent that they are now 7% overvalued compared to fundamentals, Chaney said.
However, markets are beginning to converge from their "liquidity driven equilibrium" toward their "fundamental equilibrium" - and the fact an end to QE will indicate a strengthening economy means this gap should not be too wide when easing ends.
"Inputting 15% 12-month forward earnings growth into our dividend discount model (DDM), instead of the 7% consensus, without assuming liquidity injections by the Fed, the result (the ‘fundamental equilibrium') is broadly in line with current valuations.
"In other words, the market is currently fairly valued, even assuming the end of QE."
This sets the scene for US equities to rise by more than 10% over the next two years, Chaney said.
The situation is slightly different for European equities, currently 5% overvalued according to AXA IM's equilibrium model, given US QE could end without an improvement in the European economy.
But Chaney said both the asset class' strong correlation with US equities and its higher beta (around 1.2) will prove supportive of double-digit returns in the near future.
Emerging market stocks are more at risk, as others have suggested. Chaney acknowledged lower valuations in emerging Asia offer "a welcome buffer" to a liquidity withdrawal, and said the $1.4bn Bank of Japan stimulus programme could provide a counterbalance.
But Latin America is still overvalued by 15% compared to fundamentals, according to the group - and while Mexico could benefit from close correlation to the US, a weaker macroeconomic backdrop in Brazil makes the market "vulnerable to a further correction".
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