Reasons for Continued Optimism
Director, Global Investment Strategies
Global equities continued to move higher in September amid improving global economic growth and additional central bank liquidity. However, the International Monetary Fund (IMF) recently cut its global growth outlook for 2012 and 2013. Can global equities continue to rise against a backdrop of waning expectations for global growth?
- Overweight US. Despite some legitimate challenges to the US equity market’s upside, my outlook for the fourth quarter is optimistic. I believe investors should consider selectively adding risk to portfolios, given liquidity conditions, fundamentals and sentiment.
- Neutral weight Europe. Although European equities have rallied over the past few months, in my view current price multiples and sentiment levels suggest limited upside unless earnings growth reaccelerates, which seems unlikely for a number of reasons. Investors should continue to selectively purchase large-cap, dividend-paying/growing multinational European companies.
- Overweight emerging markets. Emerging market equities are under owned, undervalued and poised to benefit from global central bank stimulus, in my opinion. Although China may lag in the near term, I believe there are compelling reasons to invest in emerging market equities.
The following sections expand on these insights and examine the implications for global equity investors.
Global equities remain attractive
Global developed equity markets continued to move higher in September, up 2.5% (as measured by the MSCI World Index).1 Although liquidity and/or the expectation of further monetary easing has been a key driver of the rally, other factors have come into play as well.
Global manufacturing, as measured by the J.P.Morgan Global PMI (Purchasing Managers Index), increased for the first time since April of this year, and new orders readings rose in both the global manufacturing and services PMIs, suggesting the recent momentum in manufacturing should continue.2 The Citi Global Economic Surprise Index for G10 countries turned positive last month for the first time since April and continued to rise in October.3 Copper prices and the Kospi Index, a common measure of the Korean stock market regarded as a leading indicator of global economic growth, have increased significantly since July – further testament, in my view, that the global economy is beginning to improve.4
However, the IMF recently cut its global growth forecasts for 2012 and 2013 to 3.3% and 3.6%, respectively.5 The 2012 estimate, if realized, would be the slowest growth rate since the 2009 recession.5 The IMF now sees “alarmingly high” risks of a steeper slowdown.5
I have stated on multiple occasions that liquidity trumps fundamentals until it doesn’t. At some point, fundamentals do matter, and a steep economic slowdown is not currently priced into equity markets. This month’s commentary will address these concerns and explore what I believe could be the likely direction of global equity markets.
October has been known as a notorious month for equity returns, especially after a strong third quarter. Investors may seek to take profits. Additionally, this month analysts tend to adjust their earnings expectations for the remainder of the year and provide guidance for the following year, affecting investors’ expectations and the direction of the equity market.
Equity gains also could be threatened by some legitimate concerns about fundamentals, including:
- Economic growth remains lackluster despite the Federal Reserve Board’s (the Fed) stimulus so far. Even with three previous quantitative easing programs (QE1, QE2 and Operation Twist) and a $1.75 trillion liquidity injection by the Fed, the US economy grew at an anemic 1.3% in the second quarter of 2012.6
- Third-quarter earnings on a year-over-year basis are expected to decline for the first time since the economic expansion began in 2009.7
- The job market remains discouraging. The recent decline in the unemployment rate from 8.1% to 7.8% exaggerated the improvement made in the job market. The current unemployment rate was more a function of the decline in the number of people looking for jobs and the hiring of part-time workers. What didn’t change last month was the U-6 report, (which measures the number of unemployed and underemployed workers) at 14.7%.8
- Political gridlock in Washington is likely to continue, which increases the odds of a recession with the approach of the “fiscal cliff” — the expiration of certain tax cuts and stimulus spending at the end of this year.
To be sure, the US equity market is not priced for a recession — nor should it be, in my opinion. Here is why:
- Unemployment claims are declining, which tends to be a leading indicator of future job growth.
- The Economic Cycle Research Institute (ECRI) Weekly Leading Index, the year-over-year percent change in The Conference Board Leading Economic Index (LEI), the Institute for Supply Management (ISM) manufacturing index and the Citi Global Economic Surprise Index all confirm the economy is improving and moving further from recession.9
- The outcome of the elections and the end of the lame-duck session of Congress should alleviate some uncertainties for the business sector, enabling hiring and increased capital expenditures.
- I believe the fiscal cliff will be avoided. I can’t imagine a politician voting to send the US economy into recession. If Congress doesn’t agree to extend the Bush tax credits, I believe the equity market could fall enough to make politicians change their vote as they did after the first Troubled Asset Relief Program (TARP) vote was defeated and then unanimously passed after a 700-point decline in the Dow Jones industrial Average.
Add risk selectively
I continue to believe investors should maintain an overweight to US equities. As this chart shows, there are historically compelling reasons to be optimistic about the fourth quarter and beyond. Keep in mind, though, that past performance is no guarantee of future results.
Compelling Reasons for Optimism
The recent outperformance of small caps over large, value over growth and the cyclical sectors (materials, information technology, consumer discretionary) over the noncyclical sectors (utilities, health care, consumer staples) is, I believe, consistent with the two consecutive monthly increases in the LEI and the additional quantitative easing. As long as the LEI continues to rise, the current direction of the equity market and sector outperformance trend could continue, in my opinion. Longer term, in a low interest-rate world, I believe income-oriented investors will continue to gravitate toward high-dividend-yielding and dividend-growing stocks.
On a thematic basis, investors may want to consider owning large-cap, dividend-paying/growing multinationals, which look attractive in a low interest-rate world. In addition, establishing a 5% to 10% position in the energy sector could position a portfolio for a potential conflict in the Middle East, specifically between Israel and Iran, in my view.
Europe: neutral weight
Since the end of August, European Union stocks have been up 4.7% (as measured by the MSCI Euro Index in US dollars) as of Oct. 12, and the Euro Stoxx 50 Index was up more than 24% over the past four months through Oct. 15.19 European leaders continued to make progress in developing the framework for the European Central Bank to provide low-interest-rate financing for sovereign nations that request a bailout. Spanish banks recently passed a stress test with better-than-expected results, and industrial production in France and Italy unexpectedly rose 1.5% and 1.7%, respectively, in August.20
Investors have recently been willing to pay a higher earnings multiple for less perceived risk, which I believe has been justified. European credit default swaps (which protect against default) have declined 70% in the past year.21 European PMIs are still weak but have risen the past two months.22 The Citi Economic Surprise Index for the eurozone turned positive for the first time in six months.23 A positive reading of the Economic Surprise Index suggests that economic releases have, on balance, been beating consensus. European earnings revisions have turned “less bad” but are still negative with more downgrades than upgrades.24 In my opinion, the gap between the dividend yields and real bond yields — near a 40-year high — implies equities are attractive.25 Furthermore, this gap suggests another 21% potential upside from current levels.25
However, the consensus 12-month forward price-earnings ratio (PE) of 11 times is back to its precrisis ceiling versus a 30-year average PE of 13.4.26 To have European equity markets rise materially from here, investors will need to see a reacceleration in earnings growth, which isn’t likely to happen until global PMIs trade in the 52 to 53 range from the current reading of 48.9, in my opinion.27 Furthermore, the 2013 consensus earnings growth estimate for European stocks, at 10.5%, looks too optimistic, in my view.28 Most of the sentiment indicators are now reaching quite elevated levels where subsequent equity performance is traditionally weak. I’m also concerned about a possible short squeeze (a rapid rise in value caused by options traders covering their short positions) in the US dollar/euro exchange rate, which could take the euro to €1.40.29 This would have detrimental effect on European corporate earnings, in my opinion.
I therefore believe that European equity valuations are appropriate given the current level of uncertainty and potential for earnings sluggishness over the remainder of the year. In this environment, investors should continue to selectively purchase high dividend-paying, large-cap European multinational companies, in my opinion.
Emerging markets: overweight
China is the dominant force behind emerging market equity sentiment. At 18% of the MSCI Emerging Markets Index, China is as important to the emerging markets as the technology sector is to the US equity market.30
Chinese stocks are likely to continue to underperform the broad emerging markets index until the year-over-year percentage change in money supply (M2) begins to rise, in my opinion. I believe smaller emerging market countries are more likely to drive performance within emerging market equities for now.
That said, there are three reasons to consider overweighting emerging market equities, in my opinion:
- Under owned. The Bank of America/Merrill Lynch September Fund Manger Survey showed that fund managers’ allocations to emerging market equities are below long-term averages and that this has been the longest stretch of below-average allocation since early 2009.31
- Undervalued. Some Asia ex-Japan equity valuations are back to 2009 levels.32 Russia trades at 5.1 times forward earnings, half of the MSCI Emerging Market Index’s valuation (10.3 times), which trades at a discount to developed markets (13.09 times).33
- Policy stimulus. Unprecedented monetary stimulus out of the US and Europe has been matched by emerging market central banks, which have cut rates 52 times in the past 12 months.30 In the past, emerging market equities responded positively to QE, rising 107% after QE1 and 18% after QE2. Since QE3 was announced, emerging markets performance (5.8%) was more than double that of developed markets (2.5%) in September.30
In the US, technical, fundamental and sentiment indicators support the case for higher equity prices, in my opinion. In Europe, current valuations, sentiment measures and the elevated risk premium seem appropriate to me, given that the recession is expected to deepen, consensus earnings estimates remain negative and the sovereign debt crisis remains unresolved. Investors should consider continuing to overweight high dividend-paying and growing stocks in the US and Europe, which should stay in demand as central banks around the world reduce interest rates, in my view. Investors should also consider overweighting emerging market equities when they appear underowned, undervalued and responding positively to monetary stimulus, in my opinion. Finally, I believe investors would be well-advised to take a position in energy in case another conflict in the Middle East threatens oil production.
The opinions referenced above are those of Richard Golod as of October 16, 2012, and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results.
All investing involves risk including the risk of loss. Diversification does not eliminate this risk. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Small- and midcap stocks carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors and the amount of any dividend may vary over time based on the business prospects of the company.
This material is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor. It is not a solicitation or an offer to buy or sell any security or investment product.
All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment making decision. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing.
The MSCI World Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indexes: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK and the US (as of May 31, 2011). J.P.Morgan Global PMI is a monthly measure of global business conditions based on surveys from the manufacturing and services sectors in more than 20 countries. PMI (formerly Purchasing Managers Index) is a commonly cited indicator of the manufacturing sector’s economic health calculated by the Institute for Supply Management. The Citi Economic Surprise Index for G10 countries measures how a variety of macro indicators “surprise” relative to expectations for the countries included in the Group of 10 (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the UK and the US). The Kospi Index is a capitalization-weighted index considered representative of the Korean stock market. Economic Cycle Research Institute (ECRI) Weekly Leading Index is an economic indicator used to forecast turning points in the economic cycle, similar to LEI but updated more frequently. The Conference Board Leading Economic Index (LEI) is an economic indicator used to forecast changes in the business cycle. It’s calculated by The Conference Board based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply, interest rates, among others). The Institute for Supply Management (ISM) Manufacturing Index is a commonly cited gauge of manufacturing conditions based on surveys of more than 300 manufacturing firms conducted by the Institute for Supply Management. The Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The National Association of Home Builders/Wells Fargo Housing Market Index measures home builders’ sentiment about the sales conditions for single-family homes, based on surveys conducted by the National Association of Home Builders. The MSCI Euro Index is designed to measure the equity market performance of countries within the European Economic and Monetary Union, which include Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal and Spain (as of May 30, 2011). The Euro Stoxx 50 Index measures the performance of 50 stocks from 12 eurozone countries (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain) and is considered the eurozone’s “blue chip” index. The Citi Economic Surprise Index for the eurozone measures how a variety of macro indicators “surprise” relative to expectations for eurozone countries. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index comprises 21 emerging market indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey (as of May 30, 2011). An investment cannot be made in an index.