Feature Stories | Jun 14 2013
This story was first published on June 5 for subscribers only but has now been opened for general readership.
– Global markets shifting to "risk on"
– Low inflation underpins monetary easing
– Global credit trade crowded
– Corporate earnings growth is key
By Greg Peel
Global investment manager Standard Life Investments believes that a stronger corporate sector and improving market confidence will slowly lead investors globally back into equities and property and out of fixed income assets. Standard Life’s head of global strategy, Andrew Milligan, expects to see corporate earnings pick up as policy makers take more action to sustain global activity. Positive free cash flow, high dividend yields and solid company balance sheets will support equities through the remainder of 2013, Milligan suggests.
The global equity market has already staged a significant rally from mid last year as investors have shifted away from a post-GFC defensive stance still evident in 2012, and towards the addition of more risk. Europe appears to have settled down, the US recovery has become more recognisable, rhetoric from the new regime in China has been comforting and Japan has taken off. Underlying the “risk on” shift has nevertheless been the prevalence of global monetary stimulus, whether by direct quantitative easing (QE) or through interest rate cuts. In recent months, no less than fifteen central banks across the globe have cut their cash rates.
Yet the sharp rally to date, which has already seem some correction (Japan, Australia), has not drawn mainstream retail investor support. Rather, the search for yield in a low interest rate environment has inflated stock prices, with a significant shift out of fixed income yet to materialise. As the following graph illustrates, global investors switched quickly into cash in 2008 and began to reduce cash positions once the US Federal Reserve’s initial QE program began in 2009, but shifted money into bonds more so than in equities. The question now is as to whether a more traditional “risk” rotation out of bonds and into equities and other risk assets will transpire.
The inflation of stock prices in the search for yield has occurred as a reflection of low returns on fixed income and not of an improving outlook for corporate earnings, hence a sharp rebound in price/earnings (PE) ratios. In a sense it’s been more of a “lesser of the evils” choice, with many companies jumping on the bandwagon to lift payouts and pander to the dividend hungry investor. Typically the stock market is a forward-looking indicator, such that prices run first before earnings catch up to justify prices. Thus PE ratios expand as confidence improves before consolidating as earnings growth is confirmed.
Improved confidence is assisted by equity analyst forward earnings forecasts. Typically, forward expectations will indicate earnings growth ahead to justify stock price appreciation. Analysts are not always right of course, and indeed they’re often very wrong, hence forecasts are being constantly revised.
The relationship between global stock prices and global equity analyst forecasts is exhibited in the following graph.
This graph tracks stock prices (blue) not against historical earnings or against forecast earnings but against net revisions to forecast earnings (black). What is immediately clear is that while stock prices tend to run ahead of historical earnings, they tend to lag earnings revisions.
Note the recession of 2002-03. Upward forecast revisions were being made well before stock prices responded. In the period 2004-07, stock prices were running to the moon when earnings revisions had begun to trend downward (less positive). Then came 2008.
In 2009, the Fed introduced QE1 and analysts assumed, erroneously as it turned out, earnings would quickly return to former glory levels. Stock prices responded rapidly but revisions again began to trend downward (less positive, then negative) as Europe wobbled, while stock prices remained focused on QE2 and then QE3. From 2012, forecast revisions have remained negative, yet stock prices have again flown.
Forecasts have become less negative most recently but the fact remains there is a big gap between stock prices and earnings revisions. That gap we could call the “QE gap” given low interest rates have forced the search for yield in the stock market. If stock prices again trace out a lag effect, then we are in for a big fall in stock prices, one might assume. But are we?
It must be noted, and Fed chairman Ben Bernanke is happy to agree, that extensive QE is unprecedented, and thus a bold experiment with an unpredictable outcome. If we assume global QE will ultimately succeed, then we can also assume earnings revisions can turn positive once more without stock prices having to collapse to re-establish the relationship apparent in the graph.
This is the assumption Standard Life is cautiously making.
The intent of global monetary easing is to force the global economy to grow out of its post-GFC funk. Yet for all the money thrown at it to date, the global economy has hit a soft patch in 2013, as Standard Life notes. Growth in the US is moderating due to the fiscal sequester and tax increases. Growth in China is moderating due to measures to calm down property markets and due to a stringent anti-corruption drive. In Europe, fiscal policies are not coordinated with monetary policies and there are recessions in too many member states. In the UK there is a squeeze on household incomes from taxes and inflation.
Global inflation is nevertheless contained. Labour markets in Europe, the UK and US are weak, restraining core inflation. Wages are growing in China but inflationary effects are curbed by productivity improvements. As the following graph indicates, inflation in major economies has endured a wild ride since the GFC but stability has more recently returned to core inflation (ex food & energy) numbers.
Subdued inflation allows central banks to concentrate on growth, notes Standard Life, without fear of over-easing. At present the only real concern would be a sharp jump in commodity prices in the form of, for example, a Middle East oil supply shock. While not impossible given current, escalating unrest, Standard Life does not consider such a shock likely.
Japan has become the story for 2013, having joined the bold QE experiment in spectacular fashion. The Abe government has “launched two arrows” in the form of fiscal stimulus and removing the independence of the Bank of Japan, with a lot of the blame for Japan’s double-decade of deflation having fallen at the BoJ’s feet. The next triggers are Abe’s planned structural reforms, although these will not commence until the June election ratifies the new prime minister’s mandate.
Standard Life is remaining cautious on Japan until it is evident just what reforms will be implemented (assuming election success) and just what the response will be from Japanese households and businesses. If Abe is targeting 2% inflation, will wages rise by 2% to help push Japan out of deflation? If so, Standard Life does not expect this to be evident until 2015.
If Japan is the new centre of attention, Europe is the legacy issue. It took some time but the European Central Bank has acted on the monetary policy side, although Standard Life believes more could be done. Fiscal policy is becoming slightly more flexible as policy makers slowly realise the imperative of boosting economic growth, yet closer fiscal union is needed.
Fiscal union still seems far off, but a lot will rest on the German general election in September. Assuming Angela Merkel wins the election, it will still be important as to how well she wins, suggests Standard Life. The election will be a referendum on Merkel’s closer fiscal union policy. Little in the way of major eurozone decisions are expected before the election, and in the meantime political problems are evident in France, Greece, Italy and Spain.
Vital to fiscal union, insists Standard Life, is that of fiscal transfers between states. Australian states may be parochial, but a federal government ensures unimpeded interstate fiscal flows. Hence Australia is a “country”, but Europe is not. Many wonder whether Europe might follow Japan down the path of decade-long deflation but Standard Life believes it is dangerous to view the eurozone as one country. It is more likely individual states will face deflation (Italy for example, and maybe even France) yet as a collective, Europe is still running a current account surplus. Europe, with Germany at the helm, is a net global lender, not a borrower.
Within Europe, of course, there remains a cohort of net borrowers, being the eurozone disaster cases of Italy, Spain, Portugal, Ireland and Greece. As the following graph illustrates, eurozone debt panic has eased in the past two years, which is one reason the global “risk on” trade has re-emerged. Standard Life nevertheless remains very cautious on European assets.
Before investors began to turn to the stock market for yield, they turned to the corporate debt market. Credit spreads on corporate debt, which indicate perceived default risk, recovered quickly from the panic-driven GFC spike, but soon blew out again on European problems and the US debt issue – specifically the Congressional fiscal stalemate and the downgrading of US government bonds in 2011. As corporations have subsequently deleveraged and repaired balance sheets, investment funds have flown into high-yielding corporate debt. But that is now becoming a “crowded trade”, as Standard Life notes.
Credit markets are not as attractive now as they were. Investors continue to look for yield opportunities in a world of low government bond yields but corporate spreads are vulnerable from a government bond sell-off, earnings risk or asset class rotation (into equities). Bond defaults can be contained, Standard Life suggests, as long as balance sheets are robust and earnings show positive growth.
It all comes back to earnings.
Standard Life’s mid-year global outlook for 2013 concludes as follows.
Strategically, sustainable yield remains the core approach for portfolios – a major decision for 2013 is if and when to move from credit into global equity and real estate. Such decisions will be determined by credit valuations and the economic backdrop, confidence recovering and the corporate sector putting its cash balances to work.
The House View is starting to look for growth opportunities, including more specific country and currency positions, as the risk on, risk off environment evolves. The world economy has entered a soft patch but the US, China and Japan can lead a moderate global economic recovery into 2013.
Politics is still influencing portfolio risk – policy decisions or policy errors will decide how many investors next move tactically.
The following table outlines Standard Life’s asset class views, moving on a scale from heavy to light portfolio allocation weightings.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.