A back-to-basics approach to investment with a focus on valuation is needed and too much of a focus on style investing will be a distraction as markets struggle to keep the recovery on track
Markets need to see their expectations of a significant economic recovery if they are to continue rallying. Markets initially rallied in response to fiscal and monetary policy easing and the possible release of pent-up demand due to geo-political uncertainties. They now need to see tangible positive economic outcomes to keep the recovery on track.
The omens do not look promising. The all-important US economy has exhibited a degree of unresponsiveness to policy easing relative to previous economic cycles. Investment, industrial production, consumer spending, to a lesser degree, and the employment numbers have not been boosted as much as may have been expected.
Most of the recently announced leading economic indicators remain mixed at best but there is cause for greater optimism for the third quarter when household incomes will feel the greatest benefit from tax cuts.
US employment data will probably be the single most important indicator going forward if the expected economic recovery is to be sustained.
The consumer has responded vigorously to the Fed's substantial easing of monetary policy, availing himself readily of the opportunities for cheap credit and mortgage re-financing. However, this has had a couple of less encouraging side-effects.
The first is that household balance sheets are beginning to look rather stretched and the second is that there is no pent-up demand for interest rate sensitive 'big-ticket' items, normally a powerful driver of cyclical recovery. Any weakness now in employment data would thus risk a period of depressed confidence.
In Europe, despite Germany being officially in recession by virtue of recording two consecutive quarters of negative GDP growth, there are encouraging signs from a very low base. Chancellor Gerhard Schroeder has staked his career on reinvigorating Germany's stagnant economy. He has unveiled moves to cut government spending, shake up the tax system and deregulate the labour market. However, any tangible effects from these changes are unlikely to be seen until at the middle of next year.
None of this is to pretend that the European economy is anything other than very subdued. Despite improvements in recent indicators of consumer confidence and purchasing managers' intentions, it is likely to remain so particularly in light of the stronger euro. The point is that European markets have generally been priced for a low level of expectation.
Encouragingly in the UK, the Bank of England believes a modest recovery is the most likely prospect. Moderate growth in consumer spending, accompanied by strong growth in public spending, a gradual improvement in the contribution of net trade and a modest increase in business investment were all cited by the bank as factors that will aid a recovery. Of course, central banks are nowadays very much in the business of managing expectations. This means we should take account of the fact UK growth has been heavily dependent on a debt-driven consumer boom, which must call into question the sustainability of that growth, while any improvement in net trade probably depends on a slow-down in UK growth relative to her trading partners.
Nonetheless, beneath the macro-economic mist, the micro-economy may in fact be slowly improving. Corporate margins are being restored, admittedly through cost control rather than top line growth, but this augurs well for future profitability even if incremental demand remains muted.
Increasingly, companies are meeting or surpassing earnings expectations, and more importantly, being tentatively rewarded by equity markets for doing so. This is encouraging, as is the recent increase seen in corporate activity.
However, within the global arena, sufficient excess capacity and corporate indebtedness still exist to maintain sub-par growth rates and a disinflationary bias.
Significantly, accommodative monetary and fiscal policy throughout the developed world is testimony to this. In the absence of outright deflation/depression, to which we ascribe a low probability of occurring, it is reasonable to assume growth will gradually begin to revert upwards towards its potential, though probably not as early as 2004, as the consensus expects. In this scenario, the current output gap will gradually close and global economic activity should move back towards trend levels.
A relatively subdued outlook for growth is not necessarily harmful to equity valuations. The issue is really more to do with a reasonable level of expectations. A strict adherence to the basic principles of valuation will therefore be paramount in today's markets and undue obsession with style factors such as large vs small capitalisation stocks, value vs growth or chasing momentum, a popular game in the late 1990s, will essentially be a distraction.
It seems reasonable to expect that prospective returns from equities are likely to be more in line with their long term historical averages and thus well below the perceived 'norm' of the 1980s and 1990s.
On an asset allocation basis, valuation factors favour an overweighting of both the European and particularly the Asian and emerging markets over the US. Valuations of stocks in the US are still too high.
My main concern is that the quality of reported earnings is not good enough and the high level of exceptionals, such as charges for impairment of value, is unacceptable. Companies appear to be experiencing regularly recurring exceptionals year-on-year when by any definition an exceptional should be a one-off event.
There is also a problem with the fact the vast majority of companies do not expense the cost of option grants to management and employees and use unrealistically high return assumptions for their pension fund assets. In combination, these factors mean US equities are being incorrectly valued and are still trading on unrealistic multiples, which is concerning. And from a historical basis the market yield is far too low.
Within a global equity portfolio an underweight position in the US by default leads to some bias towards European stocks. While the market rally over the past few months means valuations are no longer as appealing as they once were, they are by no means overly expensive.
Furthermore, while the larger economies on the continent are having difficulties, the smaller countries are seeing reasonable economic growth and performance. However, the recent spotlight placed on the rising currency is a development that needs monitoring, particularly its impact on growth and corporate performance.
In Asia. regional valuations, in absolute terms, and relative to developed market peers, are compelling. Companies are in good shape thanks to aggressive cost cutting and restructuring efforts.
Asia also does not have to deal with the distortions in earnings seen in the US caused by pension liabilities and stock options. Companies have also embraced the importance of creating value for shareholders by way of dividends and share buybacks. Dividend yields across the region continue to be healthy, with the Thai market offering around 5%.
World stock markets now need to see forecast levels of economic and profits growth come to fruition to justify current valuations, particularly after the recent sharp back up in bond yields. It remains my view that there are structural issues within the US economy which may act to impede a 'normal' response to an exceptionally easy policy stance.
Given the starting point and the scale of existing imbalances, it is difficult to see how the US can realistically be expected to act as the global engine for growth when so much of the normal cyclical firepower has already been expended. This means the premium multiple afforded dollar assets may be unjustified and further weakness in the currency can be expected. These views are reflected in our current asset allocation.
In the wider context, and in a post bubble environment, investors may do well to reflect on the lessons of history on issues ranging from valuation principles to the level of returns which can reasonably be expected from a long term investment in equities.
World stock markets need to see forecast levels of economic and profit growth come to fruition to justify current valuations.
A strict focus on valuation is needed rather than style investing.
Growth will be in line with long-term historical trends and below that of the 1980s and 1990s.
Valuation factors favour overweighting both European and Asian and emerging markets over the US.
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