Goldman Sachs’ Edward Perkin and Katie Koch mull the equities Equinox
Edward Perkin, CIO of International Equities GSAM and Katie Koch, head of GPS internationally have reviewed the factors in favour of equities exposure.
No one could have missed the bond bull market. Bonds delivered higher returns than equities from 2000-2012, with volatility similar to cash. The strong risk-adjusted returns drew net inflows of almost 50% of fixed income funds’ average assets under management from 2008-2012. Meanwhile, equity funds lost roughly 10% of assets in net outflows during the same time period,1 as global economic growth sputtered and the European debt crisis crawled into a fourth year. It hasn’t felt like a bull market for equities-and yet it has been. Even after pulling back in June, equities are still sitting near all-time highs.
Is it too late to buy equities? Central banks in developed markets have pushed interest rates to near zero, leading investors to lower their return expectations for many asset classes. Equities, for example, will not benefit from the extra risk-free return that normally boosts their total return. Despite the recent increase, real bond yields remain negative in several markets, where modest inflation offsets the exceptionally low nominal interest rates.
However, the combination of continued easy monetary policy from central banks, gradual improvement in economic growth in several economies around the world and attractive valuations in a number of markets might make equities a good choice for investors seeking positive, inflation-adjusted returns.
Easy (Monetary Policy) Does It
The past four years of unprecedented central bank easing have been a boon for equity markets. In light of explicit commitments from a number of central banks to lower rates contingent on employment thresholds, inflation and currency targets, easy conditions are likely to continue, which should support equities. The US Federal Reserve recently suggested it could begin reducing its monthly purchases of securities, but only on evidence of better economic growth. Downside risk to equities is likely to be limited, as better growth should outweigh the slower rate of purchases.
Low interest rates tend to drive corporate mergers and acquisitions, and strong M&A trends usually boost equity valuations and markets. Financing is cheap, and companies are currently incentivized to invest record-high levels of cash, which is earning almost nothing at record-low interest rates.
In the meantime, companies have been using cash to buy back their own equity and boost share prices.
The Element of Surprise
Sluggish economic growth, or outright recession, has been the driving force behind the central banks’ actions. Belowtrend GDP growth, which has dampened sentiment for equities in the last few years in some places, is slowly picking up and should provide a more encouraging backdrop for corporate earnings growth as consumer confidence and capital expenditure increase. Importantly, recent research shows that the combination of positive GDP growth surprises and reasonable valuations are key factors linking a region’s economic growth and outperformance of its stock market. GSAM’s estimates for global GDP growth are 3.1% in 2013 and 4.0% in 2014. While this year’s estimate is still below the long-term trend of 4.1%, the level appears strong enough to support revenues, but also leave room for upside surprises in some regions.
Slowly improving outlooks for the global economy and Europe’s debt crisis have reduced some of the macro risks for equity markets, though a sharp reversal in either of these situations, in tandem with the re-emergence of significant tail risk, could curb enthusiasm.
Corporate profit margins, which have risen to multi-decade highs, present another risk to equities. As capex picks up from restrained levels, profit margins may begin to fall. Declining margins are not necessarily negative for equities if they are the result of valuable, growth-driving investment; however, when margins fall because of a drop in revenues or a rise in expenses, it may signal trouble for a company and subsequently pressure the stock price.