Executive summary

Europe's woes continue to dominate investors' attention, with May's weak equity returns driven by uncertainties with the Greek election and the expectation of an imminent bailout in Spain. Disappointing economic data in the US, Europe and China further weighed on markets last month. While much of the bad news has already been priced into the markets, I believe the broader investment landscape has changed, which will likely result in increased equity volatility for the time being. In my opinion, noncorrelated investments may help to buffer equity volatility in a long-term portfolio for those investors who are suitable.

• Overweight the US. Despite recent weakness in labor market data, the US economy is in a much stronger position than it has been in several years, in my opinion. I believe investors may want to continue to overweight large caps over small caps, high-quality over low-quality and high-dividend over low-dividend companies. Dollar strength could benefit companies that derive the bulk of their revenues from domestic demand over multinationals. The financial sector has continued to surprise on the upside, which could potentially benefit value managers.
• Underweight Europe, and be selective. Although the future of the eurozone is at stake, the future of the European multinational large-cap companies is not, in my opinion. While the region will likely experience low economic growth for an extended period, European regional stocks are underowned (with insurance and pension funds' exposure at 10-year lows) and undervalued.¹ Although the strategy carries its own risks, I favor a "dogs of Europe" stock portfolio that focuses on high-dividendpaying multinational companies that may benefit from the weakness in the euro.
• Overweight emerging markets. In a "risk-off" world, emerging markets have tended to underperform. However, the asset class is extremely undervalued, by my measures, and additional monetary stimulus could provide a positive backdrop.

The following pages expand on these insights and examine the implications for global equity investors.

Changes to the investment landscape

Financial advisors and investors alike appear frozen in their decision-making processes as the European debt saga streams over the airways in real time. Greece is currently in the spotlight as election results are analyzed, but in my opinion, the real risks are in Spain and, to a lesser extent, Italy. Spanish 10-year bond government yields are currently trading above 7%, a level that prompted bailouts for other European Union (EU) countries in the past.² Regardless of the outcome, I believe the investing landscape has changed, and investors will need to be cognizant of these changes to navigate what will likely be multiple bouts of "risk on/risk off" investing, with abrupt trading shifts that strongly favor either higher risk asset classes (risk on) or lower risk asset classes (risk off).

First, investors should plan for low economic growth in the developed world for another 10 years. That's what history tells us about countries exiting a credit crisis. Furthermore, those countries with more bloated fiscal and consumer debt levels are likely to take even longer to deleverage and return to trend growth.

Second, countries experiencing below-trend economic growth are likely to be more sensitive to exogenous shocks that result in recessions. Economic cycles in the developed world will see shorter expansions and longer contractions, in my opinion.

Third, as a result, equity-market volatility will spike more often than normal. I believe volatility is like airplane turbulence. For first-time fl yers, it can be pretty scary. But more seasoned fl yers tend to regard it more as an inconvenience. So, expect to be inconvenienced.

Investors seeking to reduce fl uctuations in their long-term portfolio may consider adding more noncorrelated assets to their portfolios. Please keep in mind such investments involve risks and may not be suitable for all investors. I do not believe the long-term answer to increased volatility is to hold cash or bonds yielding 1% to 2%.

The case for global equities endures

I still believe equities will be one of the top-performing asset classes over the next three to five years and are worth the risk because of low expectations, low interest rates and low valuations, as well as accommodative global monetary policy and strong corporate balance sheets. In a yield-hungry world, investors are likely to gravitate toward equities that produce a higher dividend yield than the yields on fixed income at some point. Not until that day comes are we likely to see equities rerate and begin a secular bull market. Until then, I believe investors should expect to see the S&P 500 Index trade in its 2011 price earnings/range, between 11.9 to 15.9 times earnings.³

The world is showing signs of slowing, but I believe global equity valuations are already pricing in a lot of the bad news. US industrial production for May was weak, and regional manufacturing surveys suggest this slowdown will persist.⁴ The preliminary June Thomson Reuters/University of Michigan Michigan Consumer Sentiment Index slipped to 74.1 from 79.3 in May.⁵ This drop reverses all the gains in sentiment this year. The mid-40s readings in the French and German purchasing managers indexes (PMIs) in May strongly suggest that an economic contraction at the "core" in Europe may be unfolding.⁶ US leading indicators (the Conference Board's Leading Economic Index and the Economic Cycle Research Institute Weekly Leading Index of US economic growth) are pointing to ongoing economic duress for several quarters.⁷ Emerging market data also continue to indicate economic weakness. However, global equities' price-to-book value is 1.5 times, the same level as last year's bottom and 30% below the 40-year average of 2.1 times.⁸

Investors and their financial advisors should question and review current positions to make sure their portfolios are optimally positioned for a more volatile world.

US: overweight

The US economy is in a better position to weather a storm, domestically or from abroad, than at any time since the recovery began, in my opinion.

For the first time since the recovery, the US may begin to see organic growth despite disappointing job growth. Energy prices continue to decline (Brent crude down $30 since February); food prices are 14% lower today than year-ago levels; low interest rates should continue based on the Federal Open Market Committee's (FOMC) commitment to maintain low interest rates until 2014; and bank lending policies are improving, according to the Federal Reserve's senior loan officers bank lending survey.⁹ Housing, which has been a drag on the economy and consumers' net worth, had the first year-over-year increase in April at 1.9% (excluding distressed sales).¹⁰ Moreover, in a perverse way, problems in Europe could benefit the US consumer via a stronger dollar, which increases purchasing power.

Although employment growth has lost traction over the past few months, forwardlooking data suggest the job market may improve. While declining 0.1 point to 94.4 in May, the National Federation of Independent Small Businesses (NFIB) Index of Small Business Optimism remains near its highest level since the start of the last recession.¹¹ Both job openings and hiring expectations improved, with job openings at their highest level since June 2008.¹² This is positive for the job market and suggests the recent deterioration in hiring may be ending. Staffing services provider Manpower Group reports a net 11% of US employers plan to increase hiring in the third quarter, the highest share in four years.¹³

The Organisation for Economic Cooperation and Development (OECD) composite leading indicator for the US, which identifies turning points in the economy, was unchanged in April at 101.2 but still remained at the highest level since December 2007.¹⁴

I believe economic data do suggest some weakness but not to the degree the stock market is implying. The S&P 500 Index's 6% decline in May ranked among the top 10 worst May performances since 1930.¹⁵ Considering the index's first-quarter performance was its best quarterly gain since 1998, the market's retreat recently is not out of the question.¹⁶ Furthermore, during election years since 1930, April and May have historically been the worst-performing months, while July and August have generated the best monthly performance.¹⁷ Keep in mind that past performance is no guarantee of future results.

Not surprisingly, pessimism abounds. Investor sentiment, as measured by the American Association of Individual Investors (AAII) Investor Sentiment Survey bullish index, at 27.45 for the week ending June 7, has traded lower only two weeks since the S&P 500 Index's Oct. 3, 2011, bottom.¹⁸ However, I believe low investor sentiment has tended to be a buy signal, arguing for potentially higher equity prices.

Another measure of investor fear — the spread between the S&P 500's earnings yield and the yield on 10-year U.S. Treasuries — is trading more than two standard deviations above its mean since 1960 (indicating a rare event).¹⁹ Since 1950, the S&P 500 Index has historically generated positive returns averaging 14.6% in the 12 months following such an extreme yield gap.²⁰ Of course, past performance is no guarantee of future results.

The S&P 500 Index is pricing earnings growth of -4% for the next five years.²¹ There have been only two other times since the March 9, 2009, market low when the equity market priced earnings growth lower than -4%.²² However, earnings expectations are rising, as measured by the three-month earnings revision ratio (ERR).²³ The three-month ERR rose from 1.0 in April to 1.2 in May, which means analysts are now making more upward than downward revisions to estimates.²⁴ Furthermore, the ERR has improved for six consecutive months.²⁵

In this environment, I believe investors should continue to overweight US stocks over those of other regions of the world. In the past, the leading economic indicator (LEI) has been a valuable tool in identifying asset class and sector outperformance, in my opinion. That the LEI's year-over-year percentage change is still declining suggests to me that investors should continue to overweight large-cap, high-quality companies that have a history of increasing dividends, primarily in the noncyclical sectors of the market.²⁶ Given that the trade-weighted dollar has appreciated 5% over the past four months, large-cap companies that derive the bulk of their earnings domestically could continue to be supported by a strengthening dollar.²⁷ The financial sector was up 5.5% from the June 4 mini-correction (on the J.P.Morgan trading loss announcement) through June 18, which may bode well for large-cap value stock performance.²⁸ Investors may want to think about moving to a more balanced allocation between large-cap value and growth for the remainder of the year, in my opinion.

Europe: underweight, and be selective

In Greece, the conservative New Democracy party — which backs the bailout and austerity measures — will begin trying to form a pro-bailout coalition government after eking out a slim victory. The bad news is Greece's willingness to live up to its obligations under current agreed-upon austerity measures will continue to come into question.

However, I believe Spain represents a larger risk in Europe. Spain is the fourth country to ask for and secure external financial assistance earmarked for the banking system. Initially, it was thought the €100 billion loan to Spanish banks would solve their immediate needs, but the yields on 10-year Spanish government bonds trading above 7% say otherwise.²⁹ According to Ned Davis Research, Inc., "There are roughly €300 billion in loans associated with Spain's real estate sector (mostly developers), over half of which, €180 billion, have been classified by the Bank of Spain as 'troubled.'"³⁰

Central banks around the world are standing ready to inject liquidity to offset the negative impact of uncertainty. The European crisis provides reason for Chairman of the Federal Reserve Board Ben Bernanke to slip in another round of quantitative easing (QE), which I believe now seems more likely. Preparing for a Greek exit from the EU (which remains a possibility, in my opinion) should yield bold proposals to "ring fence" the remaining EU members from contagion. Time is running out for just talk — it is time for "shock and awe."

Meanwhile, European economies continue to slow. The eurozone composite PMI came in at 46 in April, the lowest reading since June 2009.³¹ Germany is now showing that it has not managed to decouple from an area with which it does 65% of its trading — industrial production in Germany slid a worse-than-expected 2.2% in April and now stands at 0.7% lower than a year ago.³²

While the future of the eurozone may be in question, I believe the future of large-cap European multinational companies is not. European equities' dividend yields relative to the German bund yields have not been this high since the 1920s.³³ Furthermore, in a recent Merrill Lynch/Bank of America survey of fund managers, Europe was the most unloved region, and eurozone equities were considered the most undervalued across all regions.³⁴ In fact, 45% of fund managers believed eurozone equities were undervalued, and no other region has ever been considered as cheap in the survey's history.³⁵ Investors looking to take advantage of poor sentiment should focus on large-cap multinational companies that could potentially benefit from the depreciating currency. Although the strategy carries its own risks, I believe a "dogs of Europe" strategy — seeking high dividend-paying stocks in the non-financial sector — could generate outperformance relative to other stocks in the region.

Emerging markets: overweight

The situation in Europe has continued to take a toll on emerging market equities. That said, the price-to-book value of emerging market equities is close to 2008 lows, which would suggest limited downside from current levels, in my view.³⁶ I believe investors may want to consider overweighting emerging market equities despite recent disappointing economic announcements. China's manufacturing PMI dropped 2.9 points in May, the most since February 2010.³⁷ While this decline would suggest economic weakness, it is typical by historical standards. In fact, the PMI has historically declined in May throughout its seven-year history.³⁸ However, new orders, a leading indicator, grew at the fastest pace in more than 18 months.³⁹

The People's Bank of China cut its main lending rate for the first time since December 2008, which I believe is a positive. The decline in infl ationary pressures would be conducive to more monetary stimulus, which has tended to be positive for this asset class. Additional monetary stimulus could likely reverse the current economic downturn. I believe that emerging market consumers in countries that peg their currency to the US dollar may also benefit from lower infl ation via increased purchasing power. Investors should focus on managers who are overweight companies that derive the bulk of their earnings from domestic growth, in my opinion.

Final thoughts

Global economic growth is slowing. Low global equity valuations would suggest much of the risk is already priced in. However, investors seeking to reduce volatility in their portfolio may want to consider adding more noncorrelated assets. That said, I believe low investor sentiment, the pessimism priced into corporate earnings and current measures of risk suggest the risk to the equity market is more likely to the upside. I hope investors don't let this correction go to waste.

Important information

The opinions referenced above are those of Richard Golod as of June 18, 2012, and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results.

All investing involves risk including the risk of loss. Diversification does not eliminate this risk. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Small- and midcap stocks carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer's board of directors and the amount of any dividend may vary over time based on the business prospects of the company.

This material is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor. It is not a solicitation or an offer to buy or sell any security or investment product.