Insights Q3 Outlook: Plain sailing
Quantitative easing (QE) is about to be scaled back because US private employment seems to be improving and the fiscal deficit as a percentage of nominal GDP is rapidly shrinking. Of course, we all know that the mere mention of QE tapering, driven by the US Federal Reserve, was enough to send equities scurrying for cover in the second quarter. But should we necessarily take it as read that the third quarter will be the same?
The looming slowdown in QE does represent a relative tightening of monetary policy, but we should not forget that the policy is still very accommodative. Looking back at previous interest rate hikes from the Fed, the equity market normally weakens in the first one to three months. But history only gives half the truth as QE tapering is not comparable to normal interest rate hikes. The equity market has already discounted the projected slow pace of QE tapering as the US economy is still not expanding at trend growth. With global equities having recouped the initial shock and with the discount now in place, trouble ahead is more likely to come from the political noise emanating from the German elections on September 22, the US debt ceiling or a new confidence dip in Europe’s government bond markets. Otherwise, equities will continue to discount an improving global economy.
Overall, global equity markets are still trading below their historical average valuation and we expect a gradual reversion to the average valuation over the coming years. The dividend yield in developed market equity indices remains historically high at 3.4 percent. On that basis, we maintain the view that global equities will be higher over the next 12 months. In a rising growth environment with benign inflationary pressure, equities are among the most attractive asset classes. Our developed equity market ranking model, which takes value and momentum factors into account, is currently signalling that the Netherlands, Germany and France are the most undervalued markets on a relative basis. At the other end of the spectrum, our model is negative on New Zealand, Australia and Switzerland. The ranking is relative, so whether the equity market rises or falls, we expect the model’s top three equity markets to outperform its bottom three.
Corporate bond spreads are good for filtering out the noise in equity markets, thus helping to identify risky and calm periods. The corporate bond spread is currently 103 basis points, up substantially following the factoring in of QE tapering. The increase in the credit spread seems to have stopped for now and is at levels that correspond with low drawdowns if they happen in the third quarter.
US stocks feel the heat
US equities peaked in valuation terms on a weekly basis on May 17 at 14.8 x 12-month forward earnings per share, which is the highest level since March 2010. With the S&P 500 trading close to all-time highs, it is a fair question to ask if US equities are overheating. However, before going into detail, it is important to note that the US equity market is not in a bubble state when observing the Tobin Q ratio, which is published by the Fed every quarter.
Many elements are contributing to the strength in US equities. The housing market is improving despite recent weakness due to rising mortgage rates, oil and gas production is growing fast, automobile sales are increasing (about 18 percent upside exists if auto sales jump to normal levels) and overall inflation pressure remains subdued.
While many factors are increasingly brightening the outlook for the US economy and the S&P 500, the third quarter could see minor setbacks centred on the debt ceiling debate, Germany’s election or a European peripheral bond market, such as Portugal.
As the US government’s drag on the economy fades a bit in the second half and the private sector likely accelerates, we expect to see rising equity markets towards the end of the year. Our year-end target for the S&P 500 is 1,750 based on 1.7 percent growth in 12-month forward earnings per share to 117.0 and a 12-month forward multiple of 15 times, which is not unusual at this point in the business cycle and with the current outlook. The global economy, however, does not justify a forward earnings multiple above 15 times, but that may be the case in 2014.
Draghi’s magic wand
European equities are broadly our most favoured equity markets on a relative basis going into the latter part of the year, driven by benign valuation and good price momentum. Our preferred equity markets are the Netherlands, Germany, France, Ireland, Norway and Belgium.
Ever since European Central Bank president Mario Draghi pledged to do “whatever it takes” to save the euro, government bond yields and credit spreads have come down in tandem with rising equity markets and improving surveys on confidence. European banks have also increased their tierone capital over the years, stabilising the financial system somewhat. Nevertheless, European banks still remain the continent’s Achilles’ heel. Following six quarters of negative growth, the real-time GDP tracker eurocoin is now close to zero and with July’s good PMI figures from Europe, it may turn positive, which indicates that positive GDP growth may return to the euro area later this year.
With positive economic growth returning to the euro area and growth projected to be 1 percent in 2014 and 1.3 percent in 2015, in combination with a relatively low 12-month forward earnings multiple of 12.6 times, we are positive on European equities on a relative basis over the next 12 months.
The two worst-performing industry groups in Europe this year have been energy and materials, which have been driven by a weak global demand outlook and overcapacity issues. Strikes and demand for wage increases in many African countries have also had a negative impact on materials stocks. We expect energy and materials stocks to represent a good tactical and contrarian opportunity later this year as economic growth picks up. Consensus price targets for the two industry groups are also about 10 percent to 20 percent higher than current prices, indicating that sell-side analysts believe the current valuation does not reflect the long-term prospects, and we agree.
Going into the second quarter, we hesitated about being long on Japanese stocks as we said they were significantly overvalued relative to other developed equity markets. The momentum effects, however, were stronger than we expected and the Nikkei 225 Index climbed an additional 26.1 percent to its quarterly closing high of 15,627 on May 22.
Then on May 23, the Nikkei 225 Index experienced a 9.2 percent decline from its intraday high to its close. This was likely triggered by the weaker-than-expected HSBC flash PMI manufacturing for China and exacerbated by margin calls and general profit-taking. In the following two weeks, the Nikkei 225 index fell almost 20 percent, virtually erasing the quarter’s gains.
The question is whether the price action in Japanese stocks so far has been a speculative event or Abenomics is, in fact, setting the stage for a secular bull market. The weaker JPY has increased exports by 16.5 percent since November 2012 and confidence among households has surged to the highest levels since 2007. Tokyo department store sales are up 9.4 percent year-over-year as of June, the highest level since 1990 if the spikes following earthquakes are removed. It indeed looks like Abenomics and the Bank of Japan’s new monetary policy to reflate the economy is working so far.
The fiscal 2015 consensus earnings estimate on the Nikkei 225 Index is up 24.4 percent since the beginning of the year, reflecting increasing expectations for Japanese companies. Consensus estimates for GDP growth in 2013 have increased from 0.7 percent to 1.8 percent since December, while 2014 estimates are 1.4 percent, up from 1 percent, and a reflection of the growing confidence in the government’s new economic policy.
Given the acceptance of the G20 countries on Japan’s current policies, including a “thumbs up” from the International Monetary Fund, the new policies are likely to continue. In addition, Japan has its strongest government in many years after the decisive win by Prime Minister Shinzo Abe’s ruling coalition in the recent upper house election. The building blocks for a better future for Japan seem to be in place.
Despite improving fundamentals, the Nikkei 225 index is trading at the highest forward multiples among developed equity indices at 16.3 x fiscal 2015 earnings combined with slowing momentum relative to other developed equity markets. This has recently pushed Japanese stocks to our model’s least favourite equity market.
The third quarter could be a much more stable quarter for equities relative to the choppy waters of Q2. Geopolitical shocks notwithstanding, equities have already factored in the likelihood of an end to QE.
Q2 rolled with that particular punch and came back somewhat bloodied but not bowed. Whatever shocks hit home in Q3, it’s unlikely that the talk or even the implementation of QE tapering will be at the heart of it. Look elsewhere for the trigger.