Even after two years of strong equity performance, investors still see fundamental attractions from ...
Even after two years of strong equity performance, investors still see fundamental attractions from owning equities, while also being well aware of the downside risks. Here we examine a number of important drivers that, on balance, should reassure global investors about the prospects for many equity markets.
The key driver is profits, reflecting a solid economic environment during this more mature phase of the business cycle. We anticipate trend or 'trend-plus' economic growth this year, which together with further corporate restructuring should allow double-digit earnings growth to be achieved in many markets. Other positive drivers include strong corporate cash flow leading to improved dividend payouts, capital discipline at the corporate level via subdued jobs hiring, and a pick-up in mergers and acquisitions.
There are certainly a number of negative issues, which global investors need to monitor. Shocks to growth could come from currency instability or a resurgent oil price.
As long as these risks are manageable, our analysis suggests investors have underestimated the likely strength of the corporate sector as a key driver of equities and that, consequently, investors will be rewarded for owning equities where valuations are reasonable.
Last year saw investors successfully navigating an uncomfortable combination of headwinds. Election uncertainties in the US raised the equity risk premium, while Iraq reminded investors about the terrorism premium. Investors were faced with a continued decline in the dollar, at times threatening to become disorderly, as well as much higher commodity prices, and therefore headline inflation, than the consensus forecasts. Strong currency areas, such as the eurozone and Japan, experienced growth concerns.
Despite these issues, equity markets performed creditably over the year, and outperformed government bonds and cash. However, through the course of the year, equity markets generally de-rated as strong earnings growth outstripped rising share prices.
Our valuation analysis involves a variety of models, comparing financial assets against each other, against their history, and forward looking for example through the equity risk premium.
Here we focus on two simple approaches. The de-rating of equity markets seen recently has brought historical P/E ratios down to more justifiable levels.
In the UK and Europe, for example, the ratios are 12-15 times, which is acceptable in the current low inflation environment, though ratings are slightly higher in the US and Japan.
A second approach is to compare the relative yields on bonds, cash and equities. The declines in bond yields, the limited degree of monetary tightening by central banks, and the improvement in both dividend and earnings yields across many equity markets, has led to a noticeable improvement in the relative valuations of stocks versus cash and bonds.
From these levels of valuation, investors can look forward to solid economic growth, if moderately slower than last year, and modestly rising inflation. In addition, corporate sector efforts at restructuring, cost control, outsourcing and productivity enhancement remain very much alive. This combination should enable 5%-15% pa earnings growth to be achieved across many global equity markets.
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