Goldman Sachs’ Mahindru: Equity recovery awakens corporate animal spirits

Suneil Mahindru, CIO international equity at Goldman Sachs AM, argues that the growth of M&A activity and recovering equity markets provide excellent opportunities for active investment managers.

As spring blooms across most of the developed markets, we believe the corporate “animal spirits” are indeed awakening. In our view, increased growth spending is most likely to benefit innovative companies and industries in the developed markets.

However, with an increasing dispersion of equity returns, markets near record highs and valuations near historical averages, we believe stock selection will be critical to outperforming the broader market.

Already, merger and acquisition (M&A) activity has picked up, which we view as a sign that company managements are becoming more confident and ready to spend on growth initiatives.

CEOs are getting positive reinforcement from equity investors, who are increasingly rewarding the share prices of acquiring companies, not just the target companies.

This phenomenon is hardly surprising considering a recent survey of fund managers indicated a record high 58% would most like to see companies use their cash for capex.

Therefore, while a big increase in capex still has not yet materialized, we are growing more confident-not less-that it is coming and that it will contribute to the better global GDP growth we expect this year.

Global macroeconomic growth should be an additional tailwind for developed equity markets, where central banks continue to be accommodative and inflation remains low.

While we believe the major developed markets are relatively interdependent and will all benefit from increased growth spending, they have unique drivers.

In the US, a number of conditions could fuel robust capex including pent-up demand for information technology (which is a larger industry in the US than most other markets), the build out of infrastructure to support the energy renaissance and increased construction related to the housing recovery.

Stronger capex could ultimately lead to an increase in jobs and revenues which will be an important driver of economic and earnings momentum, given limited room for margin expansion. The near-record high level of the S&P 500 reflects the relatively strong prospects for US companies.

Further multiple expansion could come from flows leaving bond markets but with valuations around historical averages, we believe stock selection will be critical driver of performance.

Europe is recovering but will lag the US on GDP growth, capex and deleveraging. Sentiment on Europe changed dramatically through 2013 and expectations may have gotten ahead of reality. Economic growth is recovering as expected, but earnings have marginally disappointed, as an appreciating euro translated to lacklustre top line results.

However, Europe is nearing a turning point. Consumer sentiment is improving, evidenced by retail sales and auto registrations, which are up across the region.

European banks are still shrinking balance sheets but we believe that lending activity in the region will be stable to increasing in another six to nine months. Earnings in the region are still well below peak, unlike many other developed markets, which leaves more room for operating leverage and earnings growth as the economy re-accelerates.

Furthermore, Europe has slightly underperformed developed market peers and therefore continues to enjoy a valuation advantage.

Japan is the global market most exposed to capex and the weak yen is a competitive advantage for Japanese industrial companies. While Japanese equities have lagged the other developed markets for several quarters, we believe there could be a number of catalysts on the horizon: the normalization of spending patterns after the consumption tax, potential for wage increases for the majority of the population by June, likely action from the Bank of Japan over the summer and the possibility of corporate earnings estimate increases in the second half of the year.

We believe innovative companies and industries will also benefit from increased growth spending and earnings growth. Sectors like Information Technology and Energy are broadly exposed to increasing capex but many other companies related to technological innovation, like online retailing, payments systems and mobile banking, are also poised to benefit.

Increased US energy production will support specialized machinery and construction companies and liquefied natural gas (LNG) ship-builders around the world.

Stocks of many healthcare companies are already being rewarded in anticipation of an environment with more generous research and development spending, increasing M&A activity and strong earnings growth.

Lastly, we note that dispersion of returns is increasing and will likely make stock selection more important. On average, companies that beat 4Q13 consensus expectations on both revenues and EPS outperformed the S&P 500 index by 2.1%, while those that missed both estimates underperformed by -3.4%.

As companies differentiate themselves with revenue and earnings growth, we believe that fundamental active managers have an excellent opportunity to differentiate their portfolios and performance.

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