The hangover for equities over the last three months, following the disaster in Japan, has turned into disappointment over economic data and concerns about Europe’s sovereign debt situation with Greece on the verge of default. These events have reduced short-term visibility for stocks but the upward trend still prevails. Despite our slight downward revision to global economic growth, the ever benign valuation in equities means that we continue to be modestly optimistic about this asset class and expect it to emerge from the fog as the economy picks up speed in the second half of the year.
Our take on global equities
To gauge the attractiveness of global equities we have done the same as in our previous quarterly outlook and updated our data on the MSCI World Index. The first striking observation is that the index has been completely flat despite trailing earnings per share climbing as global business activity continued to expand. The flat returns are due to increased concerns about economic growth and the potential impact of Greece defaulting.
Global earnings and dividend yields are slightly higher compared to the end of 2010. So, all in all, nothing has fundamentally changed since our previous outlook besides sentiment about the near-term future. Valuations are also slightly below the levels seen during the previous bull market and the earnings yield is still attractive compared to bonds. Considering our forecast for rising inflation equities should also protect investors’ real returns better than bonds.
Only in a doomsday scenario, or if there is outright run-away inflation, should equities perform worse than bonds, based on current valuations.
Technically, global equities are still in a long-term uptrend but short-term many stocks are now in a technical headwind with around 60 percent of the S&P 500 constituents trading below their 100-day moving average. Given the slowdown in economic data and the end of QE2 we expect equities to trade sideways until after the summer. If economic data improves in the second half of the year and European politicians provide further loans to Greece, as we expect in our base scenario, equities will continue higher as edgy investors slowly shift capital back into risk assets - such as equities.
This projection is the reason why we maintain our year-end targets (see table below). The drivers will be an expansion of earnings per share and modestly higher valuations on those earnings. The largest risk to our view is a significant slowdown in economic growth, but that is not our base scenario.
Geographically, we continue to be more positive on developed equities compared to emerging market equities as elevated energy and food prices will continue to weigh more on the latter. Central banks in emerging markets will have to continue to raise interest rates to curb inflation. Within emerging markets, however, we remain in favour of Russia, South Korea and Turkey due to attractive valuations. We take the opposite view on China, India and Indonesia, which are looking overstretched in valuation terms.
Corporate sales are pivotal to earnings growth. Corporate earnings and profit margins measured by the S&P 500 Index are still expanding as we predicted earlier in the year. The main driver is the lagging effect that higher spot prices in commodities have on firms as they operate on longer-term contracts. This, combined with weak labour cost pressures and low financing costs, strengthens the flexibility to adjust prices in order to offset rising input costs from commodities.
Fears that these historically high margins are unsustainable are, in our view, exaggerated - at least in the short-term. In the second half of 2011 we expect profit margins to continue to expand, albeit only slightly, as excess production factors such as labour and capital will not constrain firms’ flexibility in controlling margins. But 2012 could be the year where we see margins come under severe pressure as competition increases, financing costs surge and labour costs potentially go up.
Rapidly expanding profit margins due to aggressive cost cutting has been the main driver behind the comeback in corporate earnings. Looking ahead, growth will have to come from increasing sales, while below the surface massive share repurchase programmes will also technically support earnings per share. Sales, quarter-over-quarter, have been growing at an accelerating pace since May 2010 with only a minor dip in April 2011. The quarter-over-quarter annualised growth rate in sales, as of May 2011, stands at 9.4 percent. We do not expect sales to continue to grow at 9.4 percent annualised, but as long as the economy grows in nominal terms sales should continue to expand.
Source: Bloomberg and Saxo Bank Strategy & Research
Europe: Politicians will bail out Greece
Adding to the risk-off sentiment has been Greece’s fast accelerating course into default. With an undercapitalised European banking industry, a clean 50 percent haircut default could turn out to be devastating to German and French banks, which would have to take large losses on their income statements. Such uncertainty would probably lower the value of government bonds, thereby reducing collateral for other assets - which may set in motion a chain reaction with the potential to pull the rug out from beneath European banks. In essence, this comprises the main risk to equities in the second half, combined with a severe slowdown in the U.S. economy.
The most likely scenario, nevertheless, is European politicians doing what they know best: bailing out troubled agents in the economy by socialising the losses on tax payers. With German and French banks on tenterhooks Angela Merkel and Nicolas Sarkozy will find a solution to give Greece more aid and kick the can even further down the road. We, therefore, expect the Greek problem to be contained, paving the way for risk-taking in the second half of the year - long before the inevitable outcome of the Eurozone sovereign debt crisis unfolds in an ugly way.
China is still the big unknown variable. In response to the financial crisis that really detonated with the failure of Lehman Brothers, Chinese authorities orchestrated the largest stimulus programme relative to an economy’s size in modern history. The massive liquidity injection ignited an unprecedented speculative boom that, on the surface, seems to have propelled China beautifully out of the dark years of 2008 and 2009. Beneath the surface, however, massive inflationary pressures lurk. They are filtering through the economy by maintaining real interest rates below zero. This penalises private savers and lures them into speculative endeavours in a hunt for yields. We expect the People’s Bank of China will hike rates further in order to curb inflation, which will slow down the tiger economy and thus impact global economic growth. From a valuation perspective Chinese equities are also the most expensive on the global scene and we do not recommend overexposure at this point.
Special focus: Is Mexico the next China?
China has understandably been on everyone’s lips for the last 17 years or so, as the Middle Kingdom’s economy has grown more than 9 percent annualised in real terms since 1994. This economic transformation has brought about large increases in wealth and the world’s fastest growing middle class which, in turn, has demanded higher standards of living through wage increases. With rapidly growing wages, China’s competitive advantage is fading quickly and as Boston Consulting Group said recently: U.S. firms may within five year’s time begin to bring back manufacturing jobs to states such as Alabama and South Carolina, thereby igniting an industrial renaissance.
We think Boston Consulting Group highlights a very interesting near-term trend. But we are more of the belief that Mexico will be the first hub for U.S. firms as its geographical position is better suited for transporting goods to Asia. Moreover, U.S. firms will have fewer burdens in terms of labour unions and healthcare benefits to employees in Mexico. If you look at the development in real wages since 2002 (see chart on next page) you will see that Mexico’s wages have been growing at only 0.3 percent annualised compared to 13.6 percent in China. This has lowered the wage gap between Mexico and China to only 45 percent according to the well-known investor Marc Faber. With this gap closing fast and given Mexico’s proximity to the U.S., Mexico could be one of the best long-term investments over the next 5-10 years.
Source: Bloomberg and Saxo Bank Strategy & Research