As with every year, capital markets spent much of 2014 ignoring the script. What should equity investors be prepared for in 2015? This current economic cycle still looks to have some legs, suggesting equities remain the place to be.
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However, the approach of interest rate rises suggests that returns will increasingly lean heavily on prospective earnings growth rather than valuation expansion.
Review of 2014
2014 provided several healthy reminders that we should always be wary of slavishly following the consensus.
At the beginning of this year, most forecasters were keen to go underweight the US equity market in favour of continental European equities. US equities had been leading the developed market equity rally for over four years – surely it was time for a breather? On the other hand, the Euro crisis had caused continental European corporate earnings and share prices to lag those of their US peers since the lows plumbed in 2009. But as confidence grew that the worst of the euro crisis was finally behind us, many forecasted that 2014 would see this gap between US and Europe begin to narrow. The US seems likely to close the year as the best performing region for stocks (our preferred regions are highlighted in blue). (Figure 1) In fact, as of 10 December 2014, the S&P 500 Index is on track to close 2014 with 49 new all-time highs in the year.1
Coming into 2014, rising treasury yields were a central part of most strategists’ outlook for equity markets, including ours. As we exited 2013, the 10-year Treasury was at 3% and the US economy looked ready to humiliate those predicting a ‘new normal’ of lower trend growth for the world’s most important capitalist economy. Then came the polar vortex, freezing economic activity in the US for much of the first quarter. This, combined with other factors, both domestic and international, meant that bond yields have continued to trend lower for much of the year. As a result, Financials, in particular banks and life insurers, performed less well than we would have hoped, while those sectors that we might have thought vulnerable to rising yields in safer asset classes, such as Utilities, did better than forecast.1
“We see the US recovery as well-entrenched and possibly even underestimated by many”
Our 2015 views…
The US economic recovery is becoming harder to question as 2014 draws to a close. The job market continues to heal; business confidence remains at multi-year highs; and both access to and demand for credit continues to improve. Where we potentially differ from the pack is the expected pace of the US recovery from here and the resulting path of inflation. We suspect that rapidly reducing labour market slack in both the UK and US will soon lead to faster wage growth, tentative signs of which are already emerging. This in turn may force central bankers to raise interest rates a little earlier and faster than currently planned in both the US and the UK. We continue to see the Euro zone muddling through, likely helped at the margin by a banking sector starting to look a little more fit for purpose and by a brisker international demand backdrop. We see China avoiding an economic apocalypse, with policy makers possessing both the means and the will to manage a more benign economic slowdown. Again, a more vibrant US economy will likely be helpful.
Earnings and valuations
Most equity markets in the developed world are no longer obviously inexpensive, and there are good reasons for many emerging market indices to trade at a lower multiple. (Figure 2) Therefore, we expect the bulk of returns for investors to come from earnings/dividend growth and the dividend yield available, as has been increasingly the case over the last year. (Figure 3) If a more pronounced wage inflation picture starts to materialise in the US and the UK, as we suspect, then rising interest rates are likely to provide some headwinds for valuation as a higher discount rate eats into the present value of future corporate cash flows.
In our view, the attractive regions for broad equity exposure in 2015 will be those with opportunities for generating the greatest earnings/dividend growth and dividend yields combined.
For the US, we are comfortable assuming that revenue growth for an increasingly geographically diversified corporate sector will not diverge meaningfully from the path of global real GDP, which we see growing in the region of 3–4%. Interestingly enough, if we exclude the Energy sector, where revenue growth tends to be closely linked to moves in the price of oil, corporate revenue growth has been healthier than the popular caricature for some time. (Figure 4) Excluding the energy sector, MSCI US revenues have risen over 4% per annum in the last two years. Including the energy sector, the top line has grown 3% per annum.2
Corporate profit margins in the US are high at the moment; however, factoring in balance sheet leverage and asset turnover, the overall level of profitability looks much less worrying relative to history. (Figure 5) Rising wages are likely to put some pressure on net margins. However, for the overall market’s return on equity (a broader measure of corporate profitability), some of this pressure may be offset by the non-financial corporate sector adding to balance sheet leverage, in part to fund the ongoing pickup in capital expenditure.
Putting this together, investors who are expecting earnings growth in the region of 5–10%, much as with 2014, should not be disappointed. When we add this to an expected dividend yield of 2%, it seems plausible to anticipate a percentage total return in the high single digits.
We have recommended an overweight position in US equities for much of the post-crisis period. Widespread, and misplaced, investor scepticism on profit margins and valuation, fuelled by elevated Shiller PE (price-to-earnings) and Tobin’s Q valuation ratios, have provided a consistently low bar for US companies to hop over. However, this is now less the case. With the Federal Reserve likely to be the first central bank to raise rates, we should expect a more pronounced headwind to valuations (as the present value of future corporate cash flows shrinks in the face of a higher discount rate). Nonetheless, we still see sufficient opportunity left in US equity markets to warrant a continuing overweight position for the moment, though the relative attraction of equities outside of the US is undeniably increasing.
For continental Europe, revenue growth may be a little thinner than that experienced in the US – a result of what will likely be a still subdued domestic economic recovery. However, there is much more room for profitability to rise, particularly in the banks, as the region’s economy continues to unevenly recover. (Figure 6) This bounce-back in profitability suggests that investors in European equities can expect faster earnings growth than likely found in the US and, added to a more generous relative prospective dividend yield, a higher total return.
This, allied to the fact that the consensus is just much less enamoured with European equities than it was at the start of the year, suggest to us that continental European equities should remain a key overweight within clients’ developed market equity exposure.
The large-cap UK equity market has very little to do with the UK economy. Most of the companies quoted on the FTSE 100 have the majority of their revenue exposure overseas, with a strong leaning towards Asia. The UK equity market is also heavily over-represented by commodity and energy companies relative to other major developed world stock markets. It is this latter characteristic that has kept us underweight in UK equities for much of the last few years relative to their developed market peer group.
As mentioned in our article, “Oil: Will Saudi Arabia stay the course?” we now see less downside for the oil price and suspect it may even drift up from current levels over the next year or so. Much of the rest of the commodities space still looks precarious, with precious metals particularly vulnerable as interest rate rises loom larger. However, a more sanguine view on the price of oil removes one of the key obstacles to a more positive view on UK equities.
The opportunity for a recovery in profitability is less in the UK than it is in continental Europe, but we would still expect marginally faster earnings growth than likely found in the US. In addition, sentiment towards the large-cap UK space looks more subdued, as reflected in less elevated forward price-to-earnings and book ratios relative to average. (Figure 7)
For the moment, this means that the US and Europe ex UK remain our overweight recommendations in developed world equities, though we are now less circumspect on the prospects for UK stocks and, correspondingly, a little more cautious about that overweight to US equities.
Japan and Developed Asia
We retain a neutral recommendation on Japanese equities relative to the developed world benchmark. We’ve written about this at length within our weekly publication, In Focus, very recently – Japan Update and the views expressed there still hold for us. What remains to be seen is bottom-up reform and liberalisation.
Emerging market equities
As of December 10, 2014, emerging market equities have lagged developed equities in dollar terms, thanks to the strong showing from the US equity market so far this year. However, within the EM space, it is EM Asia that has comfortably outpaced both Latin America and Emerging Europe.2 We retain a strong strategic weight to emerging markets and currently anticipate no immediate reason to add tactical weight. However, we see investors as being best served by focusing their EM exposure in Asia again. This is where macro-economic policies, corporate governance and liquidity remain most credible within the EM equity space.
This is also the area that is most closely linked to the US business cycle. (Figure 8) As mentioned above, we do see China’s economy continuing to slow and perhaps by more than the consensus is currently forecasting. However, we suspect that China’s policy makers have the capacity to avert a more unruly decline, with the brightening outlook for the US economy likely helpful. For more on this topic, please see “China 2.0: a new economic dawn” in the October 2014 Compass.
“We have good news for Banks and Life Insurers”
Two key beliefs inform our recommended sector strategy for 2015. For Banks and Life Insurers - our suspicion that interest rate rises may come earlier and faster than the consensus expects should be good news. Long bonds should also eventually react to a less questionable global growth and inflation outlook, helping to alleviate some of the squeeze on the bank sector’s profitability. A significant part of our rosier outlook for global growth is a function of a brisker pace of investment from both consumers and businesses, and this in turn pushes us towards those sectors likely to benefit – Technology and Industrials. On the flip side, because of rising yields on safer asset classes, we should see a decrease in the relative attraction of the dividend yields available from some of the more economically landlocked sectors, such as Telecommunications and Utilities.
It is always worth reminding clients of the limitations of risk predictions (and of forecasts in general!). The future is of course unknowable. JK Galbraith’s famous observation, “The only function of economic forecasting is to make astrology look respectable,”3 should always be kept in mind. Nonetheless, we can provide context and perspective and point to some of the more obvious threats that may currently exist, knowing full well that unknowable challenges and rewards will ultimately emerge. In such a context, it remains paramount to diversify across asset classes and geographies.
Nonetheless, below are a few key forces that will be worth watching as we go into 2015.
As mentioned above, interest rate rises will rise at some point, likely in 2015, in both the UK and US. As monetary normalisation looms larger, with a healthier wage inflation likely dragging it forward, we would expect capital markets to become increasingly jittery. Rising Treasury yields may well draw capital out of some emerging markets in a repeat of the ‘taper tantrum’ of 2013. Turkey and South Africa are two of the previously nicknamed ‘fragile five’ whose current account situations remain precarious. There will also be many commentators who will suggest that the US and UK economies are not ready for an exit from the monetary treatment table – ‘there’s too much debt’ will no doubt be among their battle cries. (Please see our article, “Is there too much debt?” in the November 2014 Compass.) Such views could easily coincide with softer patches of data and prompt widespread de-risking hitting both equities and the racier parts of the fixed income complex.
While the level of media coverage of the ongoing conflicts in the Middle East and Eastern Ukraine has waned recently, both have the potential to worsen from here. It is politically, culturally and strategically unthinkable for Russian authorities to allow the Eastern Ukraine to drift towards the EU and NATO. There will need to be compromise at some stage, whether with regards to the map of Ukraine or Ukraine’s ambitions to join the EU and NATO. The process seems sadly unlikely to be bloodless or without further incident. This may well continue to crimp the European economic recovery at the edges, much as we’ve seen this year in the aftermath of the tragic downing of Flight MH17.
Meanwhile, in the Middle East, the maps drawn a century ago by the British and French in the wake of the collapse of the Ottoman Empire continue to blur at the hands of the Islamic State. Of course, these are just two of the currently more prevalent geopolitical risks.
The political backdrop in Europe is likely again to be a source of some investor concern in 2015. General elections in both the UK and Spain may well witness populist parties gain significant ground. The Conservative Party in the UK has promised a referendum on EU membership if it is elected; the prospect of this may at the margin crimp international investment in the UK economy. Meanwhile, the political situation again seems to be coming to a head in Greece, where the growing popularity of left wing party Syriza may well pose a threat to the negotiated arrangements in place with Greece’s creditors. The ever-widening corruption probe in China is also worth paying attention to; as yet, the political backlash has been minimal, but this probably shouldn’t be taken for granted.
We expect equity market volatility to step up in 2015 as monetary normalisation looms larger in the UK and US. However, we think those economies have long been ready for tighter policies, and we suspect that rising interest rates, in the first instance at least, do not need to spell the end of this already elongated economic cycle. We obviously remain on the lookout for any signs of the kind of hubris that usually spells the end of the economic cycle, but as yet see few signs of sufficiently widespread private sector excess. As we’ve pointed out before, emergency-level monetary policy is starting to appear inappropriate in both the UK and the US, but after the worst decade of US growth in half a century, we suspect there remains a backlog of economic opportunities still to be made good.
This means that equities remain the place to be for the moment, even if the headwinds of already lofty consensus expectations and the prospect of interest rate rises may begin to shift some of our regional preferences a little as 2015 progresses.
Equity investing involves risk including loss of principal. International investing involves a greater degree of risk and increased volatility. These risks are magnified in emerging markets.
Diversification does not assure a profit or protect against a loss.
Barclays does not guarantee favourable investment outcomes. Nor does it provide any guarantee against investment losses.
1 Source: Bloomberg, as of 10 December 2014.
2 Source: Factset, as of 1 December 2014.
3 John Kenneth Galbraith, The Quotations Page.