Equities Fairly Valued but Upside Isn't Guaranteed

OBSR, a Morningstar company, publishes a monthly Global Investment Strategy and Asset Allocation report. A summary of the September edition follows.

Economic & Financial Market Background
During the first half of the year the global economy rebounded strongly with vigorous growth in the emerging economies being augmented by a substantial pick up in industrial production in the developed world. Growing demand had to be increasingly met from higher output rather than just inventories and both contributed significantly to GDP growth in the first half. Along with fiscal and monetary policy boosts, the manufacturing boom encouraged an upturn in corporate and household spending and the developed economies grew in a 2.5% to 3% range in the first half.

By mid-year the growth rate of global industrial production had started to falter and while a substantial downshift in the pace of manufacturing growth was predicted for the second half, the overall impact on global GDP was generally expected to be at least partially offset by continued gains in private final demand. Emerging market domestic demand was forecast to grow at a solid pace and, in particular, it was hoped that US corporates and households, although not reverting to pre-recession levels of spending, would provide sufficient support to generate a sustainable US expansion.

Recent economic reports, mainly in the US, have raised doubts about the scale and timing of this “handover” to the private sector and resulted in wide ranging cuts to both US and global GDP forecasts. Despite numerous headlines that suggest the contrary, however, very few commentators expect renewed recession in the US (even one of the most bearish economists, Nouriel Roubini, suggests only a 40% probability). As has been forecast for some time a second half slowdown is more probable, albeit to a lower level than previously projected. Even so, growth is unlikely to be strong enough to produce greater confidence in a sustained expansion as employment growth may be insufficient to generate the income gains necessary to further boost household spending. Easier monetary conditions certainly help but it is the desire to borrow that remains elusive. Unlike the consumer, however, aggregate corporate balance sheets are in excellent shape and larger businesses are able to borrow at their lowest ever levels; triple AAA-rated Johnson & Johnson, for example, sold two-year bonds at just 2.95%, and at least corporates have the financial wherewithal to increase capex and hiring should confidence allow. Overall, while the rate of growth should be sufficient to “muddle through”, it ensures a higher degree of uncertainty and vulnerability to any new/renewed “shocks”.

For once not all the month’s economic news was negative with a much stronger than expected second quarter GDP report from the EU, principally due to a 9% p.a. rate of growth in Germany. Forecasts were raised substantially for the year, even by the ECB, albeit there was little change to those for the second half of the year.

Overall, economic momentum has slipped from its high early-recovery pace and growth is clearly beginning to slow. The double-dip argument has gained some support from weaker recent data and lead indicators will likely continue to moderate in the months ahead. Double-dips are very rare, however, and although risks to growth have risen in recent months, with increased financial market volatility and greater-than-forecast fiscal tightening, emerging economies should provide sufficient support for at least trend global growth even with a sub par performance from the developed world. A reduction in policy uncertainty has also recently contributed to stabilising financial markets and at this stage a global double-dip is considered improbable.

The repercussions of the growing risks to US growth were felt most keenly in government bond markets with long dated securities producing extraordinary returns amidst high volatility. German 10 year+ bunds, for example, gained nearly 11% over August, higher than returns recorded during the financial crisis in the fourth quarter of 2008, and even sizeable upward revisions to growth rates for 2010 and 2011 had no effect. Worries over US growth and the belief that short rates will stay at current ultra low levels for the next year (i.e. banks’ borrowing costs will remain near zero) has added a combination of forced buyers and leveraged momentum players to the mix and even many economists and bond strategists now see little value in government bonds.

Of the riskier assets, equities have performed much as expected trending sideways driven by “risk on/risk off” trading. Interestingly the riskiest of assets, such as commodities and emerging markets, hit their lows around end May/early June and, while not immune to the economic news-fuelled volatility on Wall Street, have continued to trend upwards. The LMEX index (the main base metals index) is up 26% from its lows, a move hardly indicative of recession redux.

Our Asset Allocation Views
Equities It has long been forecast that 2010 would prove to be a much more difficult year for equity markets, although positive returns were and still are forecast. The main issues going forward still centre on government fiscal policies and the ability of the US economy to transition to sustainable expansion. While attempts to tackle government deficits may well come back into the headlines in future months it is doubts over the economic recovery that have taken centre stage. For those who believe, as we do, that a double dip is unlikely, equity prices are now at very reasonable valuation levels but this may not prohibit further downdrafts over the autumn. It may well take several months to determine the extent of the cyclical slowdown now underway and many investors will prefer to wait and see how this develops. For investors with a braver disposition at least the potential rewards are now more commensurate with the risks. As long as reduced economic and profit expectations are met then current valuations would suggest very reasonable upside over the next six months, but even if they falter there are some very decent dividend yields around.

There is still little to choose between the main geographic areas although Europe’s period of underperformance could be over while the emerging markets remain favoured. Currencies have been a key factor in relative returns and will likely remain so over the next several months. Investors should favour good value defensive growth stocks, high yielders and exposure to growth markets. From today’s levels, gains over the medium term should handily outpace those for most other asset classes but an ability to withstand volatility is essential.

Bonds The sheer scale of the move in the main government bond markets came as a surprise but reflects the deep unease felt by investors when hit by financial crises and perhaps the fact that cash returns virtually nothing and is expected to continue to do so for the best part of another year! For some time we had been fairly ambivalent about the level of yields over the next quarter or two (the very steep yield curve, extremely low short rates, falling core inflation and bank and overseas central bank buying) but now believe the rally is overdone and yields will eventually back up sharply. Relatively, corporate bonds are better value and should outperform governments' but they are now more a source of higher income than capital gain. Investment grade bonds and riskier credits still offer the potential for reasonable returns going forward with some further narrowing in spreads.

Property After such a strong yield impact-led recovery in capital values the property market has slowed down considerably over the past few months. The weight of money chasing high quality properties resulted in prime capital values rising by over 25% year-on-year even as All Property rentals continued to fall. With banks now becoming keener to supply the market with portfolios of properties from their involuntarily built stockpiles and spent natural enthusiasm, this should inhibit further capital gains. Selectivity is important and central London, especially offices, is a favoured area. With income in excess of 3.5% above ten-year gilts for even prime properties, however, the sector should outperform both cash and government bonds, but returns will be far lower than those achieved over the past twelve months.

Commodities Predicting commodity returns is always a difficult call given the very broad spread, high volatility and problems associated with rolling over futures contracts on returns. As long as the global economic background develops as anticipated, however, the favoured commodities, such as oil and copper where there are clear long-term demand/supply imbalances, should hold up. Industrial metal inventories are beginning to unwind and, in general, industry “experts” remain relatively sanguine about medium term prices for the key industrial metals and crude oil. Valuations of the major diversified miners are still way below April highs and look better value on the now admittedly more debatable assumption that both US and Chinese economic growth confirm even lowered expectations.

Currencies As ever currencies present all sorts of conundrums for investors. Will sterling continue to benefit from the UK’s newly found fiscal rectitude or will this be overridden by a deleterious impact on economic growth? Alternatively, will lower shorter term rates, e.g. 2 year gilts now yield 0.7%, prove sustainable in the light of rising inflation that will ensure substantial negative real returns over the next year? The best guess is that sterling may have some further upside on a trade weighted basis, given the scale of its prior collapse, but gains will be fairly limited. The euro could rally further, as the global economic slowdown replaces the focus on Europe, and it is interesting to note that it was the yen and Swiss franc rather than the dollar that led the latest “safe-haven” rally. Again the squaring of growth needs with huge fiscal and growing current account deficits provides ammunition for both bulls and bears of the dollar.