Viewpoint - More Upside

In summary

Philip Saunders, head of global multi asset shares our views on the outlook for the global economy and markets

• Threat of a renewed crisis in the euro zone continues to overhang markets, but investors ignored Greece’s default and will probably ignore the next domino to fall.
• The eventual grand finale of the euro-zone crisis may provide the last great buying opportunity before the bull market starts in earnest.
• There is no reason to believe that the opportunity will be more than very short-lived or that it will take markets lower than current levels.
• Market returns may be volatile and erratic, but there is good upside, especially in the right stocks.

The equity market rally in the first quarter of 2012 caught the media and the market Jeremiahs by surprise, but it is hard to remember a market upturn that was better flagged. The pessimists believe that the global economy and markets must come to a grinding halt until all the outstanding issues – notably the future of the euro zone and the current high oil price – are resolved, but markets have a way of making a fool of lazy predictions. Instead, global equities returned 11.9% in US dollars in the first quarter of the year (measured by the MSCI AC World Index), and the FTSE All-Share Index returned 9.1%, in sterling.

Indeed, the signal to buy equities was pretty clear around Christmas; the main factor holding investors back was hindsight worries about market volatility. The ECB’s provision of three-year money to euro-zone banks at a 1% interest rate with lax collateral requirements, which was doubled to over €1 trillion at the end of February, was a key bullish event. It saved Europe and, in turn, the world from a looming banking crisis. It did not save the euro zone – it appears that nothing can do that – but it prevented the problems of southern Europe from contaminating the world.

Euro-zone banks have inadequate capital to meet a mountain of looming bad debts, let alone the new Basel III capital requirements, but they are now able to refinance their balance sheets, shift some of their risk onto the ECB and generate risk-free profits from buying their own government’s bonds with ECB money. Furthermore, it is important to remember that, while southern Europe remains in deep recession with, we believe, no possibility of an exit while in the euro zone, it accounts for less than 10% of the global economy and markets, even if France is factored in.

Although many investors feared a ‘double-dip’ recession late last year, forecasts showed modest growth in developed economies and strong growth in emerging economies. Economic data has been not only positive but better than expected, pointing to an improving outlook. Investors have had no reason to fear that renewed global recession would undermine corporate revenues and earnings. Forecasts of these had been falling since May but, by year end, there were signs of stabilisation. While the global equity market was trading on less than 11 times prospective earnings – comparable to the rating at the market low in March 2009, when earnings were falling rapidly – such a low valuation was not justified by steady economic growth, a prospective double digit percentage increase in earnings and ample liquidity injections by central banks. Increases in corporate revenues and earnings in the US of twice the rate of nominal GDP growth show that economic growth may be sluggish, but that it is high quality private sector-led growth.

In late 2011, investors were mired in pessimism. Money had been withdrawn from the equity market, cash positions were high, and gloom was universal. Yet back-to-back down years are rare; the most notable recent example of 2000-2 being explained by sky-high valuations at the millennium, in contrast with the rock bottom valuations of late 2011. Investors who needed more convincing could have waited for the end of January, since there is a strong historic correlation between equity returns in January and the direction of returns for the year as a whole. Investors who needed even more convincing could wait for the end of February: back-to-back gains in the S&P 500 Index in the first two months of the year have occurred in 24 of the last 66 years. The average gain during those 24 years was 19.4%, with not a single down year.

Those still sitting on the side-lines have missed some great returns, and it would be a mistake to assume or hope that the market will have a significant set-back, offering an opportunity to buy into the dip. A modest setback is always possible, but the medium-term trend is firmly upwards. Flows into US bond funds in January and February were three times the flows into equity funds, showing a healthy degree of scepticism, while there were net equity outflows in March.

The turnaround in earnings forecasts first indicated in late 2011 has become a reality. There are now nearly as many upgrades to earnings forecasts as downgrades, while the trend continues to improve. Despite the market rally, equities trade at only a little over 12 times 2012 earnings, and these are expected to increase 11% from 2011. Furthermore, 2013 earnings are expected to increase a further 13.5%, putting the market on a 2013 rating of only 11. It is possible that earnings forecasts, having levelled out, will resume their down-trend but, if not, the potential equity upside is still compelling. 11% earnings growth in 2011 combined with a 3% dividend yield gives a market return of 14%, with no market re-rating, while a modest re-rating would take the return over 20%. We may have seen half that market return in the first quarter, but there is plenty more to go for. Moreover, continued earnings growth in 2013 promises further upside next year.

The key question is, what can go wrong? A short-term market setback is possible, and last year’s down-trend to earnings forecasts could resume. A further upsurge in the oil price would reduce growth, raise inflation and eat into corporate earnings but, given the weakness of coal and US natural gas prices, the oil price would have to jump to $150 a barrel to have an effect. That would be likely to stimulate additional supply, accelerate the downward trend of demand in developed markets, and curtail demand growth in emerging markets, so should prove temporary.

The weakness in government bond markets has caused some investors to worry that a sustained bear market in bonds could be negative for equities. However, this is not consistent with the pattern of recent years, in which equities and bonds have moved in different directions. Meanwhile, strong economic growth is seen as positive for corporate earnings and hence for equity valuations, but negative for bonds, as it threatens higher interest rates, while weak growth or recession undermines equities but keeps monetary policy loose. Since 1982, there have been seven bear markets in bonds, each involving losses of 15-20% in US 30 year Treasuries. Not one of these bear markets has caused a bear market in equities; two have coincided with flat equity markets (in 1984 and 1994); and five have coincided with big equity gains. A bad day for bonds may pull down equities, but on any other timescale, a bear market in bonds should be regarded as positive for equities, indicating a return of market confidence in the economic outlook and more normal financial conditions.

The threat of renewed crisis in the euro zone continues to overhang markets, but investors ignored Greece’s default and will probably ignore the next domino to fall. The eventual grand finale of the euro-zone crisis may provide the last great buying opportunity before the bull market starts in earnest, but there is no reason to believe that the opportunity will be more than very short-lived or that it will take markets lower than current levels. Until then, market returns may be volatile and erratic, but there is good upside, especially in the right stocks.

 

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