11 October 2011 at 9:34 GMT
Global equities have been slaughtered and remain in a fog with almost zero visibility. Our macro-economic models however indicate low probability of a new U.S. recession and thus based on underlying fundamentals equities look more attractive today than last quarter. The biggest risk to our view is an unpredictable spill-over of effects from disruptions to European credit markets as a result of a Greek default. However despite high volatility and maximum intervention, as John D. Rockefeller said “The way to make money is to buy when blood is running in the streets” and that is our premise for our current equity outlook.
Global equities: Attractiveness has increased despite slowdown in economy
In line with our tradition, we have collected the latest data on the MSCI World Index (see table below) in order to gauge the attractiveness of global equities. Our first observation is striking. The spread between global earnings yields and the alternative yields on AAA corporate bonds is approaching levels not seen since the months after Lehman Brothers’ bankruptcy, indicating equities have reached attractive levels for long-term investors as we expect the economy will slow down but not slip into a recession.
The super-long oriented investor should consider the following: The U.S. 10 year treasury yield is currently at around 2 percent and global dividend yields are at 3 percent. If you are indifferent about these two asset classes and you assume global companies will have unchanged dividends and market values over the next 10 years then you are still better off in equities. Does anyone really believe global companies will not have higher earnings and dividends in 10 year’s time?
If the U.S. and European economies can maintain a minimum of 1-1.5 percent annualised GDP growth then companies should be able to sustain current EPS levels and even see little growth in profits. Based on this we think equities look very attractive compared to the negative real rate returns investors are being offered in government bonds.
Looking also at the S&P 500 Index companies are now trading at 8.4x their trailing cash flow per share which is around 40 percent lower than the average 12.2 times observed since 1998. Naturally this indicates the market expects economic activity to decline and hence operating cash flows to decline as well. The latest data also shows that profit margins have continued to expand in the last couple of months combined with accelerating sales (currently 13.0 percent QoQ annualised) which could be an unexpected catalyst for EPS surprises in the third quarter earnings season.
Our equity models are currently estimating trailing EPS in the S&P 500 Index to reach 96.33 (up 5.9 percent from the end of the second quarter) at the end of the fourth quarter and the earnings yield to move about 20 basis points higher (P/E down). Despite our models estimate the S&P 500 Index is seen trading around 1,300-1,350 near year-end. We remain cautious due to massive technical headwinds and potential tail-risk from Europe’s debt crisis and thus our target for the S&P 500 Index is now 1,270 (see table above for all forecasts). Should unexpected events happen, such as a new recession (our macro models suggest if it happens it will only be a mild one), or panic in the financial system, our models point to around the 1,000 level in the S&P 500 Index by year-end. (Note: This is not our base scenario.)
Due to long and short-term technical headwinds, our models would not recommend investors go all-in on equities despite the compelling underlying fundamentals. It would be meaningful to keep some powder dry if stocks continue lower due to unpredictable events and thus increase exposure there if stocks tumble. This sounds nerve-racking for most investors but it is the most profitable strategy when you keep increasing exposure in risky assets and when blood is everywhere and panic goes parabolic.
If we see surprises in economic data going forward the biggest winners will be stocks in the financial, materials and industrial sectors. Investors that are willing to take on risk should consider those sectors as that is where the largest potential risk-reward ratio exists.
China is beginning to lose competitiveness
Following up on our special topic story from our previous outlook, trade data from the U.S. and Europe shows that China is beginning to lose market share in low-end light manufacturing and its IT electronics market share expansion has significantly slowed. So who is stealing market share? On exports to the U.S. it is Mexico, Vietnam, Bangladesh and Indonesia with the former as the most interesting story due to its proximity to the U.S., and it seems Mexico is seeing a boom in precision instruments and other higher value added products. This could very well be the inflection point of early signs of a big structural shift in global trade and thus investment opportunities in emerging markets. Unfortunately, relative valuation is not yet very compelling when it comes to the Mexican stock market which trades around 50 percent above comparable emerging markets’ valuation ratios.