Four equity markets outlooks for 2014 – NGAM
Valuation normalization, slow economic growth and the heightened importance of stock selection are a few themes a diverse group of equity managers from across Natixis Global Asset Management believe are shaping the investment landscape for 2014.
Chris Wallis, Chief Executive Officer
Vaughan Nelson Investment Management
From a US equity markets fundamental standpoint, Wallis believes 2014 will be similar to 2013, meaning very sluggish growth, no real industry trends leading the way and nothing really lagging. However, he does think equity prices will be supported by quantitative easing. “The Fed has made the clear choice that they’re not interested in tapering, much to the surprise of the market. So with the implication of increased liquidity, that will likely provide a positive backdrop for equities, and US equities specifically,” said Wallis.
If the Fed does move forward with tapering, Wallis expects it to pressure certain areas of the market, but he believes active management has the potential to do real well. “We think the equity indices can remain challenged for several years, but there are still great opportunities in individual securities,” said Wallis. He points out that the biggest headwind facing equity investors is probably pressure with corporate margins. A big part of the earnings growth of US companies has been driven by cost cutting over the past few years, as well as unusually low interest rates and tax rates. “Those elements will become headwinds for certain companies as we move forward and the Fed normalizes monetary policy. The key to this is to realize it’s going to take several years for this to occur. There’s no reason investors should expect a sudden spike in interest rates. Quite frankly, the Treasury budget, as well as the US economy in general, can’t handle that,” said Wallis. Companies that are growing earnings through operations, instead of through balance sheet management, will continue to do very well in today’s environment, he believes.
What do rising interest rates mean for equity investors?
Although it sounds counterintuitive, Wallis thinks rising interest rates mean more opportunities going forward, but also increased volatility. “We welcome corrections in the market because it gives us an opportunity to re-deploy capital. As interest rates rise, it’s going to become headwinds for certain entire sectors, which may include utilities. But in general, it’s going to raise the cost of capital, so companies that have lower rates of return are going to be challenged in their efforts to raise capital to execute their corporate strategies. That being said, it’s just going to create more separation in the marketplace. Therefore, more opportunity for selective stock pickers,” said Wallis.
As we close in on 2014, Wallis is identifying alpha-generation opportunities in the financials, industrials, retail and technology areas. “It really is across the board. And that gets back to what we think is the real opportunity set. It’s not a sector. It is a specific, individual company,” said Wallis. This selectivity sentiment also carries across to other asset classes and market caps. “Large-caps are not cheaper than smalls. Small-caps are not more attractive than mid-caps. It is going to be very specific to individual securities,” said Wallis.
The biggest trend Wallis is closely watching is the slow healing of the U.S. economy. He points out this cycle is very different than past recoveries because there hasn’t been a normal cyclical recovery in the heavy, durable items such as houses and washing machines. We have seen an auto recovery, and non-residential construction is just starting to recover. But the next big inflection point Wallis is waiting to see is household formation, which was significantly hampered by the financial crisis.
“What we actually think is going to happen is we’re going to hit an inflection over the next two years where we’re going to have to increase new home sales and production from half a million units a year to north of a million, closer to 1.5 million new homes, to keep pace with household formation,” said Wallis. When this happens, Wallis believes U.S. economic growth, employment, and interest rates would likely begin to rise.
When this happens, Wallis believes U.S. economic growth, employment, and interest rates would likely begin to rise.
Jens Peers, Chief Investment Officer
Peers has a positive outlook for sustainable equities in the New Year. One reason for this view is a macroeconomic environment that appears to be very supportive. “It may not feel right on a day-to-day basis as unemployment is still very high, but we expect positive, albeit moderate, economic growth globally,” said Peers.
Secondly, the central banks remain accommodative, which means that they will likely continue to introduce innovative and tailor-made solutions to support the weak economy. Thirdly, Peers believes valuations are still very attractive. “This combination offers a very positive outlook which, in terms of style, should be very supportive for small-cap equities,” he said. Recently, he points out that lower-quality stocks and value stocks have started to outperform. For the beginning of 2014, he expects this trend to continue, albeit reversing later in the year.
Two areas Peers sees as bright spots are finance and energy efficiency. “It is clear that with governments being short of capital to invest in the real economy, banks will have to play a more important role. What we really like are those banks that are financed in a sustainable way. This means attracting deposits and then reinvesting that money into the real economy through mortgages and investments for small and medium-sized enterprises,” said Peers.
Energy efficiency is another theme Mirova finds interesting. Peers explains that in order to generate the economic growth the world needs, more energy is also needed. “With our dependence on fossil fuels, and those fuels being finite in nature, it is clear that we need to invest in energy efficiency. There’s also more pressure on companies to lower their operating costs, which means that investing in energy efficiency has typically a pay-back period of about two years. This can have a very positive effect on a company’s operating costs,” said Peers.
From a valuation standpoint, Peers believes stock prices are at attractive prices globally. “With valuations now more in line with historic averages, we think that equity returns will be driven more by profit growth than by a revaluation of equities in general,” he said. In terms of the differences between geographic regions, the U.S. has always traded on a small premium relative to the European markets. Peers doesn’t believe this gap will close and expects earnings growth to be marginally higher in Europe than the United States in 2014. As a result, he expects a small outperformance for European equities relative to U.S. equities.
Sustainable opportunities for 2014
In energy, more specifically the solar sector, which has underperformed quite significantly in the last three years, Peers believes fundamentals are now quite attractive. “In the solar sector, what we see today is a situation where solar panels have dropped significantly in price to the level that, in many regions in the world, solar panels are cost-competitive to utility prices for electricity. That is leading to a very quick pick-up in demand, specifically in the United States,” said Peers. In China, a recent introduction of competitive prices for solar electricity is also very supportive for the solar production growth.
One of the biggest risks to Mirova’s investment thesis for 2014, in absolute terms, would be a slowdown in Chinese economic growth as that country transitions from an infrastructure-led industrial economy to a more consumer-led economy.
Lee Rosenbaum, Global Equities Manager
Loomis, Sayles & Company
Looking across global equity markets at the end of 2013, Rosenbaum believes global stocks are offering better relative value versus bonds.
Among the bright spots Rosenbaum sees for equity investors in 2014 is first and foremost the continued low interest-rate environment globally. In the United States, a slow and steady improvement in the employment picture should bode well for equities, as well. “Also in the United States, we think, as we move into 2014, there’s the potential for better GDP growth as a result of the US starting to anniversary the impacts of higher tax increases, as well as the fiscal drag,” said Rosenbaum.
Market multiples in the US and Europe have expanded in 2013. Therefore, Rosenbaum believes that going forward, further market-multiple expansion will be much harder to achieve. As a result, it will be more important than ever to find companies that have the ability to continue to grow their earning power over time. “Stock selection is always paramount. But in this environment, it is even more important, given that, broadly speaking,
global equity markets have largely completed their recovery in valuation following the 2008 to 2009 downturn,” said Rosenbaum.
In emerging markets, following the tumultuous activity and pullbacks many of these countries faced in 2013, Rosenbaum believes stock valuations have become more attractive and select opportunities could present themselves in Asia-Pacific and Latin American regions. In the developed world, valuations look broadly in line, relative to historic multiples – and in some cases slightly ahead.
The biggest headwind for equity investors in the New Year could simply be the fact that valuations have already moved back to their historical average levels across most global equity markets. “In Europe, for example, we’ve seen a similar magnitude of market-multiple expansion as we have here in the United States. However, we haven’t seen the corresponding improvement in earnings and earnings growth that we’ve seen in the United States,” said Rosenbaum. There are some signs now showing conditions in Europe bottoming and fundamentals starting to improve. However, Rosenbaum says he needs to see a continuation of that trend moving forward.
Opportunities in consumer discretionary
One of the most attractive areas to Rosenbaum is the consumer discretionary sector. “We’re finding companies with strong brands, proven business models, and the ability to generate robust free-cash flow in this sector. Some of these very companies, in the foot apparel, lodging and home improvement industries, are taking their free-cash flow today and also using it to pay dividends and, in some cases, repurchase their shares at what we believe are very attractive prices today,” said Rosenbaum.
Rosenbaum is also excited about growth trends under way in the global commercial aerospace sector. “Some of the large aircraft manufacturers have big and high-quality backlogs, providing years in the future of aircraft production. In addition, aerospace traffic is improving. And this is providing a stable and growing stream of demand for aircraft aftermarket parts and services,” said Rosenbaum.
Michael Mangan, Equity Manager
Going into 2014, the outlook for US equities remains very positive, according to Mangan. In fact, after several positive years for the broad U.S. stock market, Mangan is concerned that some investors may feel the market has become too rich. “I think an area where investors might make a bit of a mistake is that they may look at where the market has come from and where it’s gone. Certainly over the last five years it has moved up significantly from its low level. However, we need to focus on valuation, and the valuation of the US market in late 2013 is around 14.5 times earnings, while the long-term average is around 15 times earnings,” said Mangan.
As a value manager who follows a bottom-up stock selection process, Mangan does not focus on sectors but rather individual companies. That said, he continues to identify value opportunities across the automotive industry. “We have found that the auto suppliers have been very underpriced in the market, as well as some auto manufacturers. These are businesses with much improved balance sheets relative to history and much improved businesses relative to history. But they still are valued at low levels,” said Mangan. Other areas of interest include select financials and technology.
While dividend-paying stocks may have been attractive to value investors a year or two ago, Mangan believes there are very few value opportunities to be found among high-quality, dividend-yielding stocks today. “A lot of dividend-yielding stocks have been bid up quite a bit. And they’ve been bid up because of returns, or the yield in the bond market has been so low that many investors have used some of those dividend-paying names as a substitute in their bond portfolios,” said Mangan.
Chaos creates opportunity
Political uncertainty, including debt-ceiling and fiscal budget showdowns, will most likely be short-term challenges for US equity markets in the New Year. But as a long-term value investor, Mangan welcomes such chaos. “I do think these political situations can create some volatility in the market and therefore create opportunity to buy high-quality stocks at discounted prices. I don’t think the response to these events should be to move out of equities,” said Mangan.