Time to start thinking defensively, says UBS

“In short, we see the jump as fueled by improved economic data and a jump in risk appetite, though not changing our basic view of earnings, earnings expectations or valuations. Accordingly, the upside to our 13,000 target is now more limited, and so we believe investors should start to think more defensively,” UBS concludes.

Markets are almost fully priced, it says, and “earnings are entering a new, and slower phase, of the cycle.” Indeed, UBS suggests that with margins having peaked, “earnings growth will be limited by revenue growth, which in turn will broadly track nominal GDP, which looks to be in the 4%-5% range. By extension, therefore, market potential is limited.”

In this environment, “investors now need to be more cautious”, it says. “Accordingly, earnings certainty is gaining in importance, especially as relative earnings revisions has driven relative sector performance.”

UBS says it is favouring the consumer/industrial sectors that represent about a quarter of the TSX, “as their earnings revisions have been minimal and their long-term growth is in the high single digits”, it says. It also likes financials, which have “earnings certainty but lower growth”, followed by energy and materials “which have the highest expectations and are so more vulnerable to revisions.”

In terms of risks to the outlook, on the downside, UBS says macro risks include a hard landing in China’s property market/banking sector undermining commodity prices; default and exit scenarios in the Eurozone and failure of U.S. politicians to reach another compromise over the debt ceiling; and, operational issues in the resource sector, which could lead to larger than usual cuts to earnings estimates.

On the upside, U.S. growth could surprise; or, equity valuations could increase, “if operational execution is also strong and so earnings estimates come to pass.”