Warmer economy, cooler returns
Posted on 17 January 2014
It was the best of times, it was the worst of times… – A Tale of Two Cities
This has been one of the more subdued economic recoveries in recent memory, but a very good time to have owned stocks. This should not have come as a surprise.
In the US, the euro area and the UK, output has rebounded more slowly than usual. The euro area was back in recession in 2012 and early 2013, and GDP both in the region and in the UK has yet to regain its pre-crisis peak. Employment has also recovered slowly in the US, and not at all in the euro area, though in the UK it has been unusually resilient. Developed stock markets however have rebounded strongly, and started to do so before the initial recession bottomed out. In the US, this has been the best cyclical stockmarket rally since the early 1980s – and relative to bonds, it has been better even than that.
The GDP shortfall may partly reflect the statisticians missing some of the start-ups and reinvestments associated with recovery: the data may be revised a little more favourably at some stage (there have been some revisions already in US and the UK, where those jobs data suggest more to come). But given the initial financial seizure, and the aftershocks from the euro periphery and US credit downgrade, this economic upturn was always likely to lack lustre. To have invested on that basis would have been a mistake, however.
Capital markets look forward, and stock markets often do well when times are tough in expectation of them getting better. But there have been two more specific reasons for stocks doing well now. Firstly, taking the post-crisis period as a whole, this has been the best recovery on record for corporate earnings in the direction-setting US market – and predictably so. It follows the biggest-ever fall, and the key swing factor has been financial asset write-downs and their ending. Those are not directly linked to GDP. Secondly, and in our view less importantly, central banks have erred on the side of generosity, injecting liquidity and keeping interest rates lower for longer than usual.
The lesson is not to rely too heavily on the economic data. Historians and policymakers need to compare one economic cycle with another, but the results can be irrelevant or even misleading for investors. In another context the same lesson is visible in China, where two decades of sparkling GDP growth have done little for stock performance.
And now? If anything, the US economy has been gaining momentum. Last week’s soft employment report looks erratic: job creation may have frozen along with much of the rest of the country. Our economists estimate growth in the second half of 2013 at almost 4%, twice as fast as envisaged last summer, and have raised their forecasts for 2014. This will help sustain profits. In the euro area, a more tepid GDP upturn might yet translate into a vigorous rebound in earnings if banks are through the worst (a small-scale repeat of what happened in the US). But global bond yields are likely trending higher as US QE tapers, and interest rates may move into play (most quickly, perhaps, in the UK). Stocks are no longer cheap. So as the economic outlook starts to look brighter, don’t be surprised if equity returns start to fade by comparison – although we still prefer them to bonds.
Kevin Gardiner, Chief Investment Officer, Europe