Expect the ride to get bumpier, warns Investec’s King
The drivers of equity markets in 2013 have been mundane factors rather than global events and economics, says Max King, strategist and portfolio manager at Investec Asset Management Multi-Asset team.
This summer’s macroeconomic events have had remarkably little impact on financial markets. Warren Buffett once quipped, “The cemetery for seers has a huge section set aside for macro-forecasters.” Presumably it has an even larger one for the armchair analysts of current affairs. The drivers of equity markets in 2013 have been mundane factors such as valuations, earnings, cash returns to investors and fund flows, rather than global events and economics. For bond investors, it has been even simpler: government bond yields at multi-century lows had only one direction to go – up. Equity managers who spent their time picking stocks, rather than watching news channels, have enjoyed the best conditions for adding value in many years, while bond managers may still have to learn that there is no hiding place in a bear market.
Global equities are stuck between being fully valued on 2013 earnings and reasonable value on 2014 forecasts, with PE ratios respectively of 15 and 13.4, based on consensus forecasts. These project earnings growth of 11.6% in 2013 and 12.1% for 2014. With 2013 earnings half reported, the risks to 2013 numbers are now limited. Expectations for third-quarter earnings in the US are so modest that they should be comfortably beaten but estimates thereafter are more demanding. With margins already at historically high levels it seems a significant acceleration in year-on-year revenue growth, from the 2.5% average of the past five quarters, will be required to achieve double-digit earnings growth in 2014. Economic growth in the US is picking up, but perhaps not by that much.
With signs of the euro-zone economy bottoming out, investor optimism about the region is growing but the earnings trends remain dismal. Expectations for Japan are high, while earnings forecasts for emerging markets are still falling. Overall, the trend of steady downgrades to global earnings forecasts has continued. If it accelerates, equities will struggle but they should respond positively to a swing to net upgrades. The return of corporate cash to investors, rising dividends and an absence of issuance, combined with steady fund inflows means that portfolio managers have the cash to buy at any dip in the market. It has paid to remain invested and we believe that shows no sign of changing.
Small-cap and mid-cap stocks have strongly outperformed large-cap companies. There are tentative signs of the underperformance of emerging markets having ended and cyclical have outperformed defensive sectors. After four years of outperformance, US equities are now lagging the global indices while European equities have started to outperform and momentum in Japan is picking up again. For active portfolio managers and asset allocators, the opportunities have been growing.
Rising bond yields have slowed but not stopped equity returns. The 10 year US-Treasury yield reached our 2013 target of 3% but then backed off as the Fed postponed any tapering of QE. Still, stronger growth leads to higher yields; the gap between 10-year bond yields and the Fed funds rate regularly reached nearly 4% at similar stages of previous economic cycles. This points to a Treasury yield of 4% in 2014 before interest rates are first raised and a potential buying opportunity for government bonds soon after. Rising government bond yields are a significant headwind for investment grade corporate bonds but we believe the higher coupons, shorter duration and potential for credit re-rating in the high yield market offers reasonable returns.
With so many investor fears proving unfounded, it is tempting to be cavalier about the risks to markets. But these risks have not gone away. The long term consequences of QE are highly uncertain, the euro-zone crisis has been patched up rather than solved, credit growth is, at best, anaemic, threatening disappointing economic growth and fiscal deficits remain high. Corporate profitability and cash generation is high but revenue growth has been modest and a subdued level of capital spending points to low confidence. Interest rates and bond yields remain abnormally low, threatening misallocation of capital. Equity volatility has been unusually depressed and the Fed is trying hard to bail out bond investors.
The end-of-the-world doom-mongers who have been confidently predicting a collapse in equity markets since 2009 have been discredited while the bond bubble is deflating rather than collapsing. We believe the medium-term outlook for an equity-focused investment portfolio remains highly favourable but we must expect the ride to get bumpier.