Equities Outlook: Anatomy of a pullback
Posted on 28 August 2014
"Anatomy is destiny?" - Sigmund Freud
This is not the forum to tackle the question of whether the founding father of psychoanalysis would have classified equity markets as predominantly male or female (though their occasional ADHD and selective insensitivity to humanitarian crises may be all the proof some readers require). However, the summer pull back in certain equity markets, and in particular some of the accompanying moves at both the equity sector level and amongst other asset classes, may provide some interesting signposts as to where next for capital markets.
Is that it?
First, the summer pullback in developed market equities, especially in Europe, is unlikely to be the end of it. US equities dipped less than 5% and already back at all time highs. For continental European equities, the pull back has been more severe, they remain 5% below recent highs, while emerging markets seem to have so far escaped a corrective phase altogether. Despite the recent recovery, clients need to be prepared for the spectre of tighter monetary policy in much of the western world which will likely prompt a more violent reaction from capital markets than that seen to date.
For the most part, subdued inflation data, both wages and otherwise, has allowed central bankers to persuade investors that interest rates are more likely next year’s problem for both the UK and the US. In the US particularly, the first interest rate rise is widely expected to come in the second half of next year. We would still caution against complacency on this front. Our analysis, alongside a burgeoning stack of survey data, suggests that a more forceful wage inflation picture may only be just around the corner. If interest rate expectations in the US and UK are dragged forward as we suspect they might be, then capital markets are likely to have some catching up to do.
What is in the price?
This is never an easy question to answer; however, recent sector performance may be instructive. The summer pull back in equity markets can not be described as a classic risk reduction. The lack of support for the yield focused sectors such as Utilities and Telecommunications, particularly in the US, could suggest that investors are preparing for higher bond yields, in spite of a move in the other direction from both the Treasury and Gilt curves. Meanwhile strong support for Technology stocks is not exactly the classic hall mark of an investor community throwing in the towel on either risk or global growth.
Also revealing are the moves within the European government bond complex. When the euro zone crisis was at its apex, widespread scepticism of the euro’s feasibility could be seen in the dramatically widening spread between bunds and peripheral European debt. The recent drop in Bund yields has been accompanied by a drop in peripheral yields suggesting investors are not necessarily betting on a breakup of the euro zone, rather it demonstrates scepticism regarding the regions future growth and inflation prospects. This is testament to the enduring credibility of the ECB’s inventively proactive stance within its more constrictive mandate.
Global growth outlook
There are good reasons for the current pullback to exhibit the cross asset class anatomy described above: US business confidence, as measured by the ISM survey, sits at highs not seen in close to a decade while the US consumer, the world’s most important customer, will likely continue to benefit from an improving jobs market and rising asset values. Both US and UK economies look capable of positively surprising the consensus in the second half of the year.
The picture is significantly less clear in Europe. However, credit markets are already showing signs of thawing, with both demand for credit and lending standards now pointing in the right direction. The ECB’s targeted liquidity operation, due in September, alongside some likely catharsis from the end of the in depth audit of European bank balance sheets are likely to further aid this thawing process. The likely greatest relative beneficiary of this warmer credit backdrop will be small and medium sized businesses (SMEs) in Europe. Much of this segment of the economy has been starved of funding, as banks’ ability and appetite to lend to the riskier areas of the market has shrivelled in the wake of the euro crisis and a more demanding regulatory backdrop. With SMEs accounting for roughly two thirds of both jobs and value added within the EU, an easier credit backdrop will likely have important ramifications for the wider economy.
Revenues and profits
Taking the above into account, the prospects for revenue growth from the quoted corporate sector should be bright. In the US this is most apparent with a strong recent earnings season and rising profit forecasts from Wall Street. Revenue growth is central to our belief that there is no dramatic fall in corporate profitability just around the corner as many suggest. Return on Equity doesn’t look stretched relative to history and may even go higher from here as non-financial corporates begin to make more use of their balance sheets to fund the widely anticipated capital expenditure splurge.
In Europe, revenue trends remain much more subdued and real profitability some distance below the rolling 10-year average. Some of this is a function of the banking sector’s plight, with much of the rest explained by the more geographically constrained mid and small cap universe. The continental European corporate sector has the furthest to travel in order to regain previous earnings peaks, a fact, alongside our more sanguine view of the economic risks facing the Eurozone that keeps us advocating some exposure to the region’s equities in client’s portfolios alongside their US peers.
UK and Japanese equities continue to sit lower down our pecking order of favourites. For the former, it is the more defensive sector make up and heavy commodity exposure that taints our view. For Japan, we remain sufficiently sceptical of Abenomics to recommend no more than a benchmark position to the country’s equity market.
With most developed equity markets now a long way from their initial rallying point, there are many that fear that valuations must be prohibitive. Those not looking at the fundamentally flawed Shiller PE or Tobin’s Q ratios, point to the fact that on a 12 month forward price to earnings ratio of just over 15x, the S&P sits around a standard deviation above its rolling 10 year average of under 14x. Some pundits note that the 35-year average forecast price-to-earnings ratio sits down at 13x. Other commentators point out that – looking at the nine previous economic cycles – the median peak forecast earnings multiple is 15x. We would urge investors to be careful using historic averages as anything other than a rough starting point for the valuation discussion. The 35-year average is surely skewed by its first decade, when the valuation for the S&P remained below 10 times, thanks largely to a very unfriendly global economic environment marked by double-digit inflation and interest rates. This was arguably a bigger distortion than that seen in the technology boom of 1999/2000. The 10-year average will obviously be skewed by the fall-out from two major recessions.
The case for further multiple expansion is certainly getting less obvious, particularly in the context of a world where monetary policy will soon get tighter. However, we see scope for investors to still be well rewarded from just banking the proceeds of aggregate corporate earnings growth and dividend payments.
Sector strategy – positioning for rising capex and interest rates
As suggested above, we continue to look to position for the prospect of rising interest rates and a steepening yield curve. This means that we retain our overweight positions in both US and Continental European financials. We’ve liked US banks since the middle of 2012 and, though the shares have performed well in parts over this period, we still don’t think that valuations look particularly demanding in the context of a firmer economy and housing market and the likely start of a more helpful monetary backdrop for banks. Lawyers and regulators will likely remain influential, but so will brightening investment intentions, both consumers’ and businesses’. Clients may want to look further down the market capitalisation scale towards some of the US regional banks for part of their exposure. This allows more focused US exposure and the smaller banks may also face a lower legal headwind, though this shelter does obviously come at a higher valuation.
In Europe, the story is obviously different. We held off overweighting European banks until earlier this year and could have waited longer still. Much remains unanswered. A leap of faith is still required with much of the sector’s balance sheet, while the underlying economic recovery is still a fledgling, and patchy, relative to its more mature US equivalent as we have noted. However, progress has been made on a more credible supervisory system, and the banking sector’s valuation still seems more anchored to the returns it is making now, rather than the returns it will likely make amidst a slowly firming economic backdrop. The ECB’s Asset Quality Review, the aforementioned process whereby the central bank performs a full in-depth audit of the region’s bank balance sheets, is due to finish in the fourth quarter and may provide some reassurance. The ECB’s recently announced targeted liquidity operations, due to begin at a similar time, should also be helpful at the margin.
Life companies are another sector that should benefit from rising bond yields. A steepening yield curve eases pressure on revenues, policy guarantees and hedging costs. The tangible benefits to earnings can be slow to appear, but we would expect valuation multiples to expand in anticipation of the earnings effect. Life assurance stocks in both the US and Europe performed well in 2013, but valuation multiples remain below historic averages, while the recent strength in government bonds has provided some useful entry points.
The flipside is that, as yields on other asset classes rise, the attraction of some of the more economically landlocked sectors, more dependent on dividend yield to attract investors, should continue to wane. We therefore retain our underweight positions in telecommunications and utilities where valuations permit. Healthcare and consumer discretionary have been the two top performing sectors across much of the developed world for the last five years. We started cooling on consumer discretionary by downgrading the US from overweight at the start of the year, and completed that process at the beginning of the summer by downgrading UK consumer discretionary to neutral. For healthcare, we still see merit in having a slight overweight in Europe, but see prices in the US sector as having overshot likely reality and therefore suggest a mild underweight position. Confidence is building in a more pronounced recovery in corporate capital expenditure across both the UK and the US. We’ve noted several times that the average age of equipment owned by private enterprises in the US is near the oldest levels seen in over half a century. Alongside this, we see survey data suggesting that corporate investment intentions are picking up reasonably briskly. We continue to suggest overweighting the US technology sector, as well as industrials in both the US and the UK, to try and further capture this likely theme.
Emma Turner, Head of Client Philanthropy