Global Equities: Embracing Uncertainty

GLOBAL GROWTH—FROM RECOVERY TO CONFUSION

Figure 1: US markets lead the way

MSCI ACWI regional performance (USD)

Calendar Year Returns, as of 31 December 2014

Elsewhere, economic data has softened in a period when many felt the developed world would start to show more encouraging signs of growth. Europe has seen its momentum stall, while the likelihood that we are entering a period of deflation has also increased, leading to the decision by the ECB to initiate QE until inflation is on a more stable path.

In Asia, Japan’s consumption tax rise has impacted business and consumer sentiment meaningfully, and after the initial boost to sentiment from shock and awe policymaking, 2014 signified an awkward period for ‘Abenomics’ as wages rose, but not as fast as inflation. Meanwhile, with the emerging world delivering a degree of economic dispersion unrivalled in over two decades, an increasingly complex backdrop for markets has shattered what was an unusually subdued volatility environment. In many respects, these trends are now injecting into stock prices the reality of what remains an uncertain outlook for the global economy.

SHOW ME THE PROFITS!

One source of this inflection in volatility is the realization that the recovery in stock markets has been driven largely by pessimism turning to optimism, as expressed by three years of rising valuations (Figure 2). We believe that this trend has been drawing to a conclusion for over a year, but is only now being given due recognition by the market. Multiple expansion has been particularly noticeable in Europe compared to other regions, as investors have placed more weight on the hope of a durable shift to growth and profitability in the region. This hope has yet to show itself in practice, with the likelihood that after two previous years of profit declines, corporate profits in Europe fell again in 2014. Figure 3 shows regional EPS growth since the height of the last global earnings peak in 2007, with very clear divergence in regional results.

Figure 2: What has been driving equity returns?

Regional returns and change in valuation and earnings

(3 Years Ending December 2014)

Source: Factset, MSCI. Calendar year returns in US dollars.

Figure 3: Earnings reality is very uneven

Regional profits (EPS) since last cycle peak

As of 31 December 2014

Sources: Goldman Sachs, Factset, Citi research, MSCI

The highlight clearly remains the US, where corporate profits are now approximately 30% above their previous cycle high, providing some foundation for what has been a spectacular market rally. Corporate America has squeezed business models to deliver record profitability, in spite of the anaemic recovery in economic growth.

The lack of fundamental improvement from the European corporate sector, taken in tandem with strong market appreciation, has now become a central risk to European stock returns, however. While sentiment has started to waver in Europe, we have begun to find more cause for optimism (albeit from a very cautious starting point), given a belief that we may be entering a period that proves to be more fertile for European corporate profits. Quantitative easing, a weakening euro, and easing austerity measures will certainly help, as will a strengthening US economy.

What is clear is that individually and collectively, a pattern of improving global corporate profits is central to equities offering investors enough return to compensate for the added volatility that the maturing equity cycle will bring. Encouragingly, there are ample examples of companies capable of delivering such improvement at this stage of the cycle, although the uneven nature of profits delivery is highlighting a need to be selective.

VALUATIONS—NOT A BARRIER IN ISOLATION

While many would disagree, we believe valuations are best described as ‘reasonable’ for where we are in the economic cycle. We would stress that this view is premised on our belief that we will see more broad-based global earnings growth. Figure 4 reflects developed and emerging market valuations on a forward-looking P/E basis versus history. With developed world equities trading around 15-times earnings, led by US equities trading on 17-times earnings, the days of extreme low valuations are firmly behind us.

Despite this, we do not believe that current valuations should be seen as a barrier to an outlook of further, albeit more modest, returns from global equities. We would strongly disagree with statements that equity valuations are excessive, and take comfort that there have been few signs of extreme capital flows that usually signify a bubble and an extreme valuation backdrop.

For those that view equity valuations as ‘extreme’, the comparison of equity valuations and sovereign bond valuations in Figure 4 (we show implied P/E’s for the US and German sovereign bond markets taking the inverse of the bond yield) gives some perspective.

The risk of a crisis disrupting the equity cycle is ever present however, with Greece’s unsustainable debt burden and Russia’s economic and political stresses creating genuine cause for concern. These are risks, together with the evolution of corporate profits, which we will monitor closely.

Figure 4: Equity valuations are reasonable

Price/Earnings Ratio (X)

As of 31 December 2014

Comparing equity and bond P/E ratios As of 31 December 2014

Sources: IBES, Factset, MSCI.

BE ACTIVE IN THESE MARKETS

Accommodative monetary policy, a recovering US economy and low to negative cost inflation for corporates (aided by the collapse in oil prices) should all play a role in stimulating global growth and in assisting companies in their efforts to derive better results. While such a foundation is a solid starting point when thinking about global equity returns overall, especially when factoring in capital return from cash-rich corporate balance sheets, the outlook is inherently more stock-specific than it has been for some time. Policy stimulus will take time before we see any positive impact, raising the spectre of the backdrop softening before economic fundamentals improve.

Therefore, for many active investors, 2015 is likely to present opportunities to invest on bouts of stock-specific volatility. This is certainly likely if disinflation in Europe turns to deflation this year, and weakness in global energy sector earnings on the recent halving of oil prices precedes any boost to global GDP growth (Figure 5, page 4). There will certainly be data points for market bears to point to in the coming months, but we maintain a positive view that we will see a slowly improving global economy.

Figure 5: Cheaper oil—Who benefits

Impact of a $10 fall in oil prices

As of 31 December 2014

Sources: BP Review of World Energy, Empirical Research Partners Analysis, and Citigroup.

US LEADING THE WAY

An important factor underlying our stable to improving outlook, is that the US economy continues to show signs of strength. Indeed, the economy recorded its fastest expansion in more than a decade in the third quarter of 2014, underlining a recovery which had faced renewed scepticism (and outright confusion) given severely weather affected data a year ago. While economic growth has continued to improve, we are now seeing wage, capex and consumption data trend higher. This has deepened our conviction in the self-sustaining nature of the recovery.

As capacity utilization and unemployment approach 2007 levels (Figure 6), wage inflation may prove a catalyst for the much debated interest rate rises in the second half of 2015. While it is reasonable to assume that the added disinflationary pressure of the recent oil price collapse may lead to an easing of cost inflation and a deferral of the first rate rise, the trend of US economic improvement is the more important factor to monitor in our view. While the market is intensely focused on the timing of the first Fed rate hike, the absence of any such hike would likely indicate a softening of economic data, a factor that will weigh more heavily and permanently on equity fundamentals and stock valuations.

Figure 6: The US backdrop is still improving

US capacity utilization and unemployment versus last cycle

As of 31 December 2014

Source: Fed, BLS, Haver Analytics, DB Global Markets Research. 

ECONOMIC WEAKNESS AND QE

However, scepticism has been rising that a broadening of US economic strength translates to any benefit outside of the US, and by implication, whether there is a second stage to the global economic and equity cycle. This is understandable given the divergent growth backdrop in Europe (Figure 7, page 5), and the contrasting pictures of labor markets/job creation over the past three years (Figure 8, page 5). With the ECB now facing real risks to its primary policy objective of price stability (the avoidance of deflation) monetary policy is being eased to buy time for sentiment to improve among consumers and corporates who have remained more cautious than their US peers. While the effectiveness of further easing is unknown, the recognition among European policy makers of the need to act is a positive, as is the weakening of the euro for the corporate sector which may face anaemic domestic demand trends over the medium term.

In Japan, easy monetary policy has continually surpassed even the most extreme expectations; the yen has declined materially and inflation expectations have risen, while Prime Minister Abe has delivered a positive wealth effect on the back of a rising stock market. Investor sentiment, however, remains mixed. Despite aggressive monetary policy and a weaker, more export-friendly yen there is ongoing scepticism over the lack of structural change needed to address Japan's lack of domestic demand and consumption. Evidence of change will be necessary for investors to be assured that Japan is capable of leaving its ‘lost decades’ behind, but this is likely to be a multi-year process and inherently unsatisfying for those looking for near-term signs of change.

Figure 7: Global growth remains uneven

Real GDP growth estimates by country/region

As of 30 November 2014

Source: Citigroup, IMF.

Figure 8: Diverging monetary paths

Unemployment and inflation since 2012 in the US and Europe

As of 30 September 2014

Sources: Evercore ISI, Factset.

WHERE ARE THE OPPORTUNITIES GIVEN THE POSITION IN THE MARKET CYCLE?

There are clear concerns in the market that beyond QE, there is no fundamental improving 'bull' case for global equities. However, this aggregate top-down perspective on the world belies the ongoing breadth of stock-specific fundamentals that indicate meaningful return opportunities. While it is very common for sentiment to soften in the mid-stages of the equity market cycle, our view has consistently been that drivers are in place for economic stability and improvement. Linking this backdrop to stocks, companies which deliver improving business fundamentals still present excellent return opportunities.

While cyclical sentiment has been tested in recent months, a focus on areas of the stock universe with above-average economic sensitivity emerged in 2013, balancing what had previously been an unusually defensive equity market rally. With investors now expressing renewed concerns over drivers of economic growth causing a dampening of return-seeking behavior, we believe that stock specific opportunities are once again emerging in high-quality cyclical businesses. Even without the consideration of earnings expectations, when comparing industrials and consumer discretionary stocks to more defensive peers, valuations are favorable (Figure 9).

Poor performance of many emerging markets, has also led to EM indices looking optically cheap versus DM indices. It has certainly been unusual in the context of history to see EM stocks perform so badly in what has been a very strong period for global equities (see EM section on page 7 for further opinion). We believe the unusually defensive pattern of this market rally speaks in part to elevated conservatism post the shock of 2008. One question over the longer term is whether risk appetites will return. Perhaps more important than investor sentiment, we are waiting for evidence of normalized risk appetites at the corporate level, given management teams have remained cautious of investing in a period where returning capital to investors has been so rewarded via stock prices. A return to risk seeking behavior by corporates is necessary to assume a normalization of global demand trends.

Figure 9: Defensives retain previous valuations

Global sectors—Valuations and comparison to 2007 peak

As of 31 December 2014

Sources: FactSet, Wilshire Atlas, MSCI/S&P GICS Sectors. Analysis by T. Rowe Price Associates, Inc.

In the meantime, we believe caution is creating opportunity within areas that remain unloved by the market, including cyclical growth stocks in both the developed and emerging world. To evidence this caution, European cyclical stocks have been weak for much of the last year (Figure 10), even when European stocks as a whole were rising. This latter trend prompted us to add to high-quality European-listed industrials (to add to an existing overweight in the sector), as well as selective consumer discretionary stocks as the market reached a point of elevated fear last autumn.

We have also maintained an overweight position in emerging Asian stocks, in economies and industries that remain fertile with respect to year-on-year compounded profits delivery (see EM section). Such growth may merit a larger premium as investors acknowledge the end of the multiple expansion stage of the equity cycle and look to other drivers to stock returns. Elsewhere, we remain very selective (and underweight) the most defensive segments of the market, believing valuations for the most defensive businesses will continue to normalize versus the market over the next stage of the cycle.

Figure 10: Shifting sentiment in 2014

Cyclical vs. Defensive Index

As of 31 December 2014

Sources: Citigroup. Factset.

WHERE DO WE GO FROM HERE?

We have enjoyed a remarkable period for equity investing over the last six years, with the opportunity to buy exceptional companies at prices we are unlikely to see again in our generation. One key foundation to success in recent years has been the ability to stay engaged with stocks during periods of distressed sentiment in order to benefit from swift transitions from “Despair” to “Hope.” While it is always tempting to wait for patterns of recovery to be established, history reflects that the early identification of fundamentals stabilizing, or the ‘stop getting worse’ point, is key to return generation (Figure 11).

History also suggests that as we move into the “Growth” phase of the market cycle, investors may lose faith as economic momentum lulls and some companies disappoint versus raised expectations. The reality remains that corporate fundamentals over the next 12−24 months will dominate any near-term uncertainty, and we believe the equity cycle has room to continue. Specifically, we believe we are in the ‘Growth’ phase of the equity cycle—a world of dispersed valuations and corporate outcomes where sentiment will provide opportunity as it shifts stock prices more aggressively. It will therefore be important to be active when market sentiment overreacts to disappointment. A contrarian stance will be required at times, but with a focus on stock fundamentals this should ultimately reap long-term rewards for global investors.

Figure 11: Anatomy of an equity market cycle

Phases of the "typical" US equity market cycle

As of 31 December 2014

Source: DataStream, Goldman Sachs Global Investment Research.