LONDON, 9 September — Equity markets have seen significant recovery since last July. The world equity market index (MSCI World in USD) has gone up by about 10 percent. The bond markets, on the other hand, have reported only a small increase. The outperformance of equities over bonds cannot be explained by the publication of good economic figures over the last four weeks. What has happened is that the gap between economic performance and stock market performance, which had widened in recent months, has now narrowed somewhat.
The geopolitical environment has improved overall over the past four weeks. The IMF aid package for Brazil to the tune of $30 billion has significantly reduced the risk of Brazil having to default on its debt. Such a situation would be an additional burden on a global financial system already plagued by uncertainties.
Second-quarter growth figures from the US economy were published at the end of July. Growth in real gross domestic product (GDP) was a very disappointing 1.1 percent. However, the revised GDP figures for previous quarters caused even more of a stir. According to these revisions, GDP was already on a downward path in the first quarter of last year, i.e. before the attacks of Sept. 11. Whereas before the revisions there had been no recession in the United States according to the technical definition (GDP growth negative in at least two consecutive quarters), it now transpires that an entirely normal recession was taking place.
Both the Purchasing Manager’s Index, which measures the mood within companies, and Consumer Confidence, which reflects the willingness of households to spend, have fallen in the US recently. However, too much should not be read into these figures. Although the Purchasing Managers’ Index calculated by the Institute for Supply Management (ISM) has fallen sharply from 56.2 to 50.5, this Index level still suggests GDP growth of around 3 percent. Consumer Confidence (survey by the University of Michigan) also points to a growth in consumption of around 3 percent.
Reading the financial pages leaves one with the feeling that profit news, i.e. earnings estimates and reported earnings, is predominantly negative. Such announcements are currently subject to significant uncertainty as it is unclear as to how, for instance, employee stock options or goodwill amortization should be posted. In order to get round this uncertainty we use corporate earnings as they are shown in national accounting.
Corporate earnings improved back in the first quarter and we expect this recovery to continue. Why? Significant productivity gains mean that unit labor costs are falling sharply. Since wages are companies’ biggest cost component, earnings are expected to recover further.
The price/earning (P/E) ratio on the world equity markets has risen from 15.5 to 17 in the last month. Stock markets have seen sharp growth over the last month while earnings estimates have been revised downward lightly. This means that the risk premium has declined. Are equity markets already too expensive and should we reduce the share of equities in our investments?
The answer is: Definitely not. The risk premium for the S&P 500 is still at an extremely high level. In fact, the risk premium is currently almost three standard deviations above the historical average. Even if profit estimates were 10 percent too high because stock options granted to employees did not previously have to be posted as expenses, the risk premium would still be more than one standard deviation above the average.
Even with the recovery of the stock markets over the last four weeks, market sentiment remains bearish. According to the survey of US private investors carried out by Barron’s, the number of bearish responses outweighs the number of bullish ones by about 6 percentage points. Technical indicators, however, point to stocks outperforming in the coming moths. For instance, the Advance-Decline indicator, which subtracts the number of falling shares from the number of rising shares, shows a turnaround.
Our strategy continues to overweight equities due to the low valuation and the prospect of increasing profits. Technical and sentiment indicators and the somewhat better geopolitical environment also point to an overweighting of equities. And although the macroeconomic environment has deteriorated slightly, it still favors equities outperforming bonds.
In our sector strategy for equities we are reducing our overweighting in the materials sector. This sector has outperformed the MSCI world equities index by 13 percent since the beginning of the year. The materials sector is also expensive in terms of relative P/E ratios. And as an early-cyclical sector it should derive little extra benefit from the continuation in the economic upturn we expect. Otherwise, we are sticking with our sector bets. The health care and industrials sectors are overweight, the telecom and consumer staples sectors are underweight.
In our bond investments we are maintaining our short-duration bet. Although key interest rates will probably be increased later than previously expected (not until next year), and we do not expect an increase in inflation in the near future, we nonetheless anticipate rising bond yields. Why? Bond yields are currently at an all-time low. We expect investors’ appetite for risk to revive and thus see them moving funds which they had previously shifted from the equity markets to the bond markets back to the equity markets.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)
