After a strong start to 2013, markets must now negotiate their way past the Italian electorate and the US government – which begins its sequestration debate on 1 March – if they are to maintain their upward trajectory. Meanwhile, as the new Chinese administration takes office in early March, we ask how far the rally has left to run.
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Europe: austerely yours
Political uncertainty, ongoing austerity and lagging economies continue to overshadow Europe. Nonetheless, we see the (unsurprising) renewed volatility in continental markets as an opportunity to add to long-term holdings in one of our favoured investment regions.
Eurozone: mamma mia, there you go again
Following Italy’s election deadlock, it is too soon to draw firm conclusions on the likely composition of the country’s next government (let alone its policies). Nonetheless, while the election result is disappointing for investors, it needn’t be transformative for portfolios. We see the volatility that the vote has caused as an opportunity to add to positions in selected risk assets, including eurozone stocks. Renewed volatility has long seemed likely, and eurozone politics has always been a possible catalyst.
While many media and market voices will argue forcefully that the euro faces a life-threatening crisis, we doubt that the situation is that stark. It may, however, be a while before this becomes apparent: volatility may not subside immediately.
Political fluidity in Italy is of course the norm, not the exception. The average life of an Italian government since 1948 has been a little over one year. The question now is whether the fiscal retrenchment and structural reforms undertaken by Mario Monti are put on pause, or move into reverse. We suspect it will be the former.
The election result shows Grillo’s Five Star Movement to be the big gainers. The protest vote is not however enough to deliver a government that is sufficiently populist (or irresponsible) to embark upon renewed fiscal profligacy (and/or euro exit, though this may not be the part of Grillo’s platform that attracted voter support).
The most likely outcome is some form of coalition involving at least one of the parties not led idiosyncratically, which will act as ballast. Bersani’s centre-left grouping has most seats in both houses: it controls the lower house, but not the senate. This leaves Italy with a relatively small fiscal deficit (2% of GDP), a primary surplus, and a current account that is close to balance. Fiscal slippage is being tolerated by the euro partners in Spain and France, and if necessary would likely be tolerated in Italy too. The European Central Bank’s promise of conditional support in the secondary markets, for a member government that requests it, is an important financial safeguard. As we have written here many times: there are no short cuts to a lasting solution to the euro crisis, but that doesn’t mean that investors need remain on the edge of their seats while waiting.
Elsewhere, the Spanish government – not without its own difficulties over recent weeks – is still holding back from making a formal application for a bail out. Remember, once the European Central Bank (ECB) made that promise, the likelihood of member governments being able to secure funding rose sharply.
Figure 1: TARGET2 balances show stability creeping back into euro area deposits – at least, prior to the Italian vote
Figure 1 shows that intra-euro tension has eased over recent months. The cross-border balances in the TARGET2 system (the EU’s interbank payment system) seem to have peaked last summer and have been slowly subsiding as deposits have stabilised.
These balances – and of course Italian and Spanish bond yields – will be watched carefully. Meanwhile, eurozone economic data remain patchy, but with a stabilising bias – indicators from the periphery and France remain subdued, but the best-established cyclical indicator in the zone, the German Ifo survey, has again surprised positively. We expect eurozone GDP to be flat this year, but that would be a small improvement on 2012 – and a better outturn than we think is even now priced-in to equity markets.
Investment advice: Current volatility notwithstanding, we think that stocks in the eurozone – and across the wider continental market – can outperform the rest of the developed world this year. The continent may be the slowest-growing region economically, but markets are driven by outturns relative to expectations, not absolute GDP growth. As noted, we think that investors’ expectations of corporate profitability are still too low, and those of renewed euro instability too high, even after the rally in stocks to date. Continental bonds can outperform too, because they include Italian and Spanish debt where a modestly risk-on climate may eventually foster renewed spread narrowing. In Europe, as in the rest of the world, however, we strongly prefer stocks to bonds.
UK: downgraded, but not out
Poor growth data have not prevented UK inflation from continuing to exceed target. They have, however, deterred the Bank of England from trying to do anything about it. The bank now expects UK inflation to continue to exceed its target into 2015, which would take its track record of underachievement in this respect to a round decade.
The foreign exchange markets have noticed. Even before Moody’s downgraded the UK’s credit rating, sterling had been weakening. The decline has been bigger than the UK’s inflation differential, and the result is a real exchange rate that looks a little more competitive than it did. With two of the UK’s important export markets – the US and Germany – looking more animated and the bulk of the fiscal hit to growth beginning to fade, the stage is set for modest cyclical improvement. Growth in 2013 will be supported too by the fading of the one-off working-day effect that hit output in 2012.
In the meantime, we note that the employment data was telling a somewhat less downbeat story to begin with, and that the government deficit – while not falling as quickly as planned – has fallen by two-fifths since its 2009 peak (Figure 2). The first-ever downgrade of the UK’s sovereign credit rating may, therefore, have occurred at a time when the outlook is in fact brightening. The sound you may now hear in the background is that of a stable door being closed as the horse gallops away.
Figure 2: Closing the stable door: UK government balance and employment
Investment advice: we have been less positive on UK securities than on those in continental Europe, and indeed on developed markets generally. If anything, our wariness of UK government bonds (gilts) has increased in the last month, while our sentiment towards stocks has improved.
Our caution on gilts has nothing to do with the UK government’s creditworthiness, and everything to do with valuation and inflation risk. Even Moody’s does not expect the UK government to come close to defaulting on its nominal obligations; an Aa1 rating is still the second-strongest rating there is. But most gilts are trading well above par value, and yields are firmly below current and prospective inflation rates (the UK’s track record on inflation remains the worst among the old G7). If UK growth revives a little – and risk appetite with it – investors in gilts face potentially considerable mark-to-market volatility.
The currency still looks vulnerable, near term, but talk of a sterling “crisis” is premature. There is no fixed peg that needs to be defended, and the currency was inexpensive to begin with. Moreover, the scale of the recent disappointment on growth, the order of magnitude of the inflation in prospect, and now the fiscal deficit itself are, in our view, not large enough to trigger a major sell-off. Much bad news is likely already in the price, and we expect sterling to recover against the euro in the second half of the year.
In the meantime, investors worried about foreign exchange risk and familiar with derivatives might consider hedging – or simply ensure, as we advise, that they hold a balanced portfolio that includes a healthy weighting in blue-chip equities. Those stocks needn’t be listed overseas: large UK listed-companies are among the most international on the global exchanges. While their prices, therefore, are quoted in sterling, they are driven by the global markets that generate the bulk of their profits.
The UK has been one of our least favoured stock markets. This remains the case, but the cheaper currency will help boost the UK’s relative earnings momentum, and its lack of appeal has faded a little. Of course, even while underweight the UK in an equities-only context, we have strongly preferred UK stocks to gilts and cash.
US sequestration: a speed bump, not a pothole, for markets
As we go to print, US equities are on track to post a second consecutive month of gains. The advance has been broad based, with large and small companies alike enjoying investor attentions. (The S&P 500 Index rose 1.44% for the month, while mid- and small-capitalisation stocks gained 1.17% and 1.06%, respectively.1) Investor risk appetite has been fed by a strong US corporate earnings season, with fourth-quarter profit up an
average of 6.9% on revenue growth of 3.5%.2 Accompanying the results and rising equity prices – indeed a catalyst for the rise in small and mid-cap – has been increased in US merger and acquisition activity. By mid-quarter, the value of US M&A deals announced was set to exceed the full amount for the first quarter of 2012. The increased corporate acquisitiveness reflects the greater confidence corporate chieftains now have about the economic environment in which they’re operating. We expect this trend to continue – a positive for small and mid-cap US stocks – as slow but steady economic growth and postponed capital expenditure drives the need to produce earnings growth.3
With the earnings season drawing to a close, financial headlines and investor attention will turn to the policy debates around sequestration of Federal expenditures that begins on March 1, and the potential shut-down on March 31 of the Federal government due to the expiration of the continuing budget resolution. At this juncture, it seems as if sequestration will occur as scheduled since there is little inclination on the part of Congress and the White House to reach a deal that would avert the automatic cuts. The effect on 2013 GDP of the $85 billion in spending is roughly 0.50%. Given the rising private sector activity and the steady decline of government spending in recent years, the potential impact of sequestration represents more of a speed bump rather than a pothole to the nation’s economic activity. Consider the following chart, which maps the decline in public sector expenditure to corporate earnings and stock prices.
Figure 3: US real public sector (government) spending
Figure 4: S&P 500 index level and earnings
Against the expectation of fiscal battles ahead, the consensus estimate for S&P 500 earnings this year appears to be settling in at the $110 per share4 level that we posited in December.5 This is encouraging, as it makes our yearend S&P 500 target of 1,595 and the expected return of 12% to 14% more probable. (As you’ll recall, our target was based on our 2013 S&P 500 earnings estimate of $110 per share and an anticipated price-to-earnings multiple of 14.5.)
Figure 5: S&P 500 – 2013 Earnings Per Share Estimate
We continue to recommend rotation away from Treasuries and investment grade bonds into equities or floating-rate public and private debt
As expected, US investment grade and high yield fixed income returns have been challenged – flat to slightly negative – especially compared to equities. Talk of increased concern in certain quarters of the Federal Reserve about the impact of continued quantitative easing has investors wondering when the central bank’s money printing program will begin moving into lower gear. As private sector activity accelerates this year, this question will feature ever more prominently in investor discourse. Beware: Investors who wait for the Fed’s confirmation of an actual policy change will have waited too long. As we have frequently underscored in these pages and in our weekly publications, fixed income market valuations, at or near historic highs, are simply too expensive for any investor who seeks a margin of safety in a security’s price relative to its intrinsic value.
Consequently, we continue to recommend investors rotate exposures away from fixed income investments – particularly Treasuries and US investment grade debt – into US equities, or floating-rate public and private debt. The risk reward potential is clearly in favour of the latter and not the former.
Asia: a promising start to the year
Market movement in Asia has been dominated lately by developments in Japan. The continued weakening of the Japanese yen has brought a rare whiff of excitement to the otherwise dull Japanese equity markets, in part due to expectation that the weaker currency will help boost export competitiveness. But as we highlighted in last month’s Compass article “Where will Japan’s rally go next?”, the stock market’s recent returns look a lot less spectacular once the extent of the yen’s depreciation is taken into account – something international investors should note. Year-to-date, the Nikkei 225 index has returned more than 11% in local currency terms but only 2% in US dollar terms.6
Meanwhile, the latest Q4 2012 GDP data for Japan – which shows that the economy continued to contract at a rate of 0.1% quarter-on-quarter – reminds us of the magnitude of challenges that the country still faces in reviving growth.
While Japan may be the momentum trade for now, for the region overall we remain most constructive on China, with its longer-term growth potential. China’s macro data trend has been largely moving in the right direction: Its economy continues to show further signs of growth stabilization (see Figure 6) – with our estimate for China’s 2013 GDP growth at 7.9%, up from 7.8% in 2012. While the latest flash Markit Manufacturing PMI, which tracks sentiment in small-to-medium businesses, retreated to 50.4 in February from January’s final reading of 52.3, it remains expansionary, indicating that more manufacturers are optimistic about the outlook than not.
The stabilization of China’s economic outlook has also led to improved earnings expectations (see Figure 7) and higher valuations for Chinese stocks. The MSCI China Index’s current price/earnings ratio is 10, up from about 9 in October. These factors, combined with the successful transition in political leadership, make it unsurprising that Chinese equities have outperformed Asian stock markets over the last several months. Despite the recent outperformance, Chinese equities are still trading below their 10-year historical average price-to-earnings multiple of 12. Although the market may take a breather due to profit taking activities, we would view any set-back as an opportunity for investors to build exposure to Chinese equities –especially in companies that could gain from infrastructure- and/or consumption-related growth in China.
A key event to watch is the National People’ Congress (NPC), which starts in early March. While the government could introduce additional measures to support near-term growth, we do not expect any large-scale stimulus in view of the improving macro data. Rather, we will watch for further policy initiatives aimed at reshaping China into a more consumption-driven economy with quality growth. Such initiatives would include additional state-owned enterprise (SOE) reforms; plans to liberalize interest rates further and increase SOE dividend payouts to government shareholders are already starting to emerge. Some market observers have expressed concerns that the reforms may be negative to SOEs, which still account for a significant portion of the Chinese equity market. Eight out of the 10 largest weighted stocks in MSCI China are SOEs; and these eight SOEs alone account for about 45% of the index. Hence, it is likely the stock market would be negatively impacted if reforms were to cause a sudden deterioration in SOE profitability and shareholder returns. However, we believe that the process of further
Figure 6: China’s growth has rebounded
Figure 7: Improving China earnings expectations
reforms is likely be gradual, providing time for the SOEs to adapt and avoiding any sharp decline in SOE profitability. More significant, the reforms, if successfully implemented, could result in a more efficient SOE sector as well as better allocation of capital and resources in the country, supporting the sustainability of China’s long-term growth.
Like China, Asia’s key exporting economies are generally seeing signs of a turnaround as well. Take Korea. While the recent Japanese yen depreciation has brought some pressure to bear on Korean exporters, the general lift in global trade has provided some countervailing support. The country’s January trade numbers, for example, show that exports grew by a much better-than-expected 11.8% year-on-year – compared to an outright y-o-y contraction of 5.5% in December. (The median forecast was for 8.9% growth, according to Bloomberg.) Similar strength can be seen in Taiwan, where exports grew by 21.8% year-on-year in January, compared to 9.0% the month before. These exporting countries – and their respective equity markets and currencies -- will only benefit from stronger global growth.
Barclays’ key macroeconomic projections
Figure 8: Real GDP and Consumer Prices (% y-o-y)
Figure 9: Central Bank Policy Rates (%)
1 Source: Bloomberg. Figures are total returns for February. Mid-cap index is the S&P 400 Mid Cap Index and Small Cap returns are represented by the S&P 600 Small Cap Index.
2 Source: Bloomberg. S&P 500 Index companies earnings, as of February 28, 2012
3 US corporations spending on capital expenditures as a percent of profits is well below its long-term historic average: 55% vs. average of 89% since 1951. Source: Bloomberg, as of September 2012, latest available data. The need to reinvest in plant and equipment is not something that can be postponed ad infinitum.
4 Source: Bloomberg, as of February 27, 2013
5 See December 2012 / January 2013 Compass: “An American Reckoning, or Reconciliation”
6 Source: Bloomberg as of 22 February 2013.