Director of Global Investment Strategies
Stay Focused on the Long Term
Financial markets don't like uncertainty. So, when US Federal Reserve (Fed) Chairman Ben Bernanke commented on possibly reducing the level of quantitative easing (QE) at some point, it was unsurprising that volatility spiked in both the equity and bond markets. Spikes in volatility can be either a bump in the road, presenting investors with a buying opportunity, or a more ominous sign that a change in investment strategy is needed.
This month's commentary delves into why I believe the current weakness in fixed income and equity markets provides investors with another opportunity to buy the dips.
- Overweight US. I expect the Fed to reduce the dollar amount of its asset purchases eventually, but it's still too early to abandon the zero interest rate policy. Changing the dollar amount of purchases still lowers the effective federal funds rate (the actual rate banks charge each other for overnight lending), just at a slower pace. That said, until the yield on 10-year US Treasuries breaks above 2.4% to 2.5%, I believe fixed income remains in a downtrend. Equities may continue to be supported by better earnings growth and continued economic growth as the job market improves and the fiscal drag from the sequestration (automatic federal budget cuts effective in March 2013) eases. Although the cyclical sectors have recently outperformed, I believe dividend-paying stocks are correcting within an overall uptrend and should continue to have an overweight position in investor portfolios. Investors may want to shift the focus on dividend-paying stocks from the highest-yielding companies to the dividend growers and companies positioned to establish a dividend (i.e., those with high free-cash flow).
- Underweight Europe. The region continues to face headwinds, with Finland officially falling into recession, the debt level relative to gross domestic product (GDP) spiraling out of control in Spain, more downgrades than upgrades in European corporate earnings and historically expensive valuations. Investors should continue to focus on large-cap, dividend-paying multi-nationals in the defensive sectors.
- Overweight Japan. Extreme volatility last month moved the Nikkei 225 Index into a bear market, with a 20% decline in the past month.1 However, quantitative easing (QE) in the region isn't likely to change unless inflation becomes problematic. QE is likely to continue to weaken the yen/dollar exchange rate and move Japanese equities higher.
- Neutral to underweight emerging markets. Weak commodity prices mean weak emerging market index performance. However, emerging markets still have some of the best balance sheets (low debt, high savings) at the fiscal, corporate and consumer levels. The equity markets appear oversold, underowned and attractively priced. That said, emerging market equities may drift lower and a better entry point may be coming.
The following expands on these insights and examines implications for global equity investors.
Long-term uptrend remains intact
Fed Chairman Ben Bernanke's comments on adjusting QE sent shock waves through the global financial markets last month. Global stocks retreated 0.6% in May with continued declines in the first two weeks in June.2 Despite the increase in volatility, US stocks posted an increase of 1.9%, followed by Europe, up 0.5%.2 Japan was the worst performing region in May, down 5.7%, on comments from the head of its central bank.2 Emerging market equities posted another monthly decline as commodity prices continued to move lower. Commodity prices, as represented by the Thomson Reuters/Jeffries CRB Index, have slipped three of the past four months, and as of June 14 were 6.1% lower than their Feb. 1 high.3 The potential end of QE created a shift in global sector outperformance from the defensive sectors to the early cyclical sectors like technology hardware, auto and retailing.2 Utilities, telecommunication services and consumer staples were among the worst-performing sectors as investors moved away from high dividend-paying stocks and into companies with greater growth prospects.2
Bernanke's comments also led to a spike in interest rates, with global government bonds suffering their seventh-worst monthly return since 1985, according to analysis by Bank of America/Merrill Lynch.4
Gauging by the conversations I've been having with concerned financial advisors lately, investors are wondering if the environment of lower rates and higher equity markets is nearing the end. My answer is an emphatic no.
The 10-year Treasury yield spiked from 1.62% on May 2 to 2.22% on June 12, leaving many investors to believe we are in a rising interest rate environment.5 I couldn't disagree more.
The Federal Open Market Committee (FOMC) has directed monetary policy primarily in two ways. It has maintained a zero federal funds rate policy to anchor the short end of the yield curve. I believe the zero interest rate policy will continue until the inflation rate (core personal consumption expenditures or PCE) reaches the FOMC's 2.5% target. Core PCE has been trending lower the past year and currently stands at 1.05%.6 The more traditional measure of inflation, the core consumer price index, is at a 53-year low.7
The FOMC has also embarked on a QE program to reflate the economy through the purchase of longer-dated fixed income instruments. The purchase of fixed income assets lowers the effective fed funds rate. To reflate the economy, the Fed needs to bring the effective fed funds rate below the equilibrium rate (the rate that neither stimulates nor dampens the economy).
Deflationary pressures early in the recovery moved Chairman Bernanke to take a more aggressive approach to monetary policy. The FOMC increased the amount of bond purchases with each announced QE program. The current rate of bond purchases stands at $85 billion per month. The current unemployment and inflation rates are 7.6% and 1.05%, respectively.8 There is more work to be done to hit the Fed's target.
That doesn't mean the Fed won't begin to taper its bond purchases. That will happen, perhaps as early as September. But, I think investors are missing the point. Whether the Fed adjusts its monthly purchases from $85 billion to $65 billion or less, the direction of the effective fed funds rate is still lower, and the yield on 10-year Treasuries is 90% correlated to the direction of the federal funds rate.9 As long as the Fed is expanding its balance sheet, the trend in interest rates is likely to be lower, unless an outside force exerts more pressure on interest rates.
After its recent spike, the 10-year Treasury looks oversold. Historically, the 10-year Treasury yield has traded 28 basis points higher than the yield on 10-year German government bonds.10 As of June 14, the spread was 60 basis points.11
Until the 10-year Treasury breaks above 2.4% to 2.5%, I believe interest rates remain in a downtrend.
But that's just part of the story. The other component to post-recovery market performance has been corporate earnings growth. Since the recovery began, corporate profits have more than doubled, compared with a 50% average rise in previous recoveries.12 Yet, as of June 17, the S&P 500 Index was up 140% since the bottom in 2009.13 In some respect, equities are playing catch up to earnings.
Some may say that's yesterday's story, considering 80% of the market's gain this year has been explained by multiple expansion, as measured by price-earnings (PE) ratio.14 However, to me the single best predictor of earnings growth is the behavior of PE, which troughed last November during the discussions on sequester and has since shot up. Given the historical relationship between PE expansion and earnings growth, I believe earnings should embark on an upswing over the next several quarters.
Analysts also appear more optimistic lately. Analysts' estimated earnings revision ratio, the percentage of analysts raising earnings estimates divided by the percentage lowering earnings estimates, turned positive last month for the first time in 11 months.14
Further confirmation of the potential for better earnings has been the shift in sector leadership away from the defensive sectors to the more cyclical sectors, including technology.15 The sector rotation may be due, in part, to improvements in global economic data and breadth. The Organisation for Economic Cooperation and Development (OECD) Composite Leading Indicator for OECD countries and six nonmember countries increased 0.1%, and the percentage of global purchasing managers indexes (PMI) exceeding their long-term averages, at 40%, is at the highest level in a year.16
In the US, economic growth may continue to slowly improve. I am less concerned about murky readings on the health of the manufacturing sector because consumers' disposable income should increase with the likely continued decline in energy and food prices. Job growth is also likely to improve. The Conference Board's survey quantifying those who believe "jobs are hard to get" versus those who believe "jobs are plentiful" is at a level suggesting a further decline in the unemployment rate, as the spread between the two responses is 90% correlated to the unemployment rate.9
The fiscal drag will also diminish over time, estimated at $311 billion for 2013 versus $53 billion for 2014.17 I see the economic soft patch in the second and possibly third quarters as temporary.
All that said, I believe any market weakness is an opportunity to add to positions at lower prices, and I remain bullish on equities for the long term. Although past performance is no guarantee of future results, I would also point out these three historical scenarios.
- Positive streaks spanning seven or more months. As of May, the S&P 500 Index was up for the seventh month in a row. Since 1928, the S&P 500 Index has posted 17 streaks of seven (or more) consecutive monthly gains. In these instances, returns tended to be positive over the following six to 12 months, with average gains of 7% to 8%.18
- Ten-year average PE ratios. Below is a chart of the 10-year average PE ratio of the S&P 500 Index since 1980 moved forward 10 years, plotted with 10-year average returns for the index. The chart shows how historically predictive (0.86 correlation coefficient) the 10-year average PE ratios have been for 10-year equity returns.18
Equity returns have tracked 10-year average PEs
- Corporate net payout ratios. Last month, I explained that PE ratios – after taking into account corporate cash levels – were approaching levels last seen in 1982, which supports the argument that the market put in a secular low. Looking at what corporations are currently returning to shareholders (in dividend payouts and share buybacks), the net payout ratio at the end of April was 3.97%.19 By comparison, in November 2008, the net payout ratio was 6.3%.20 This suggests the current bull market may have much more upside. As of March 31, the dividend payout ratio was 36.3% and the long-term average 57.8% – I see plenty of room for further dividend growth.21
Income-oriented investors should continue to focus on dividend-paying stocks, perhaps with less emphasis on high dividend-yield companies and more emphasis on dividend-growing and high free-cash flow companies. I believe the recent weakness in defensive sectors and high dividend-paying stocks was nothing more than a correction in a longer-term uptrend. The future performance of high dividend-paying stocks will have much to do with the direction in interest rates, in my view. I would change my view on the direction of rates if the velocity of money begins to accelerate and/or signs of inflation arise. In the meantime, utilities, the cheapest of the defensive sectors, and high-yield municipal bonds, which are mispriced and misunderstood, look attractive.
Some Wall Street firms are becoming more bullish on European equities on the basis of improvement in some leading indicators (including the Markit Eurozone Manufacturing PMI and Germany's Zew Indicator of Economic Sentiment), continued European Central Bank (ECB) policy support and a general sense that the worst is over.22
I believe it's too early to add to positions in Europe, for several reasons.
- Earnings growth has yet to bottom. Europe's earnings revision ratio, at 0.62, is worse than any other region in the world.23 But valuations, measured by 12-month forward PE, for the Euro Stoxx 50 Index are at the upper end of the trading range over the past 10 years, at 12 times forward earnings.24
- The region continues to have tight lending standards, very little credit growth, intense deleveraging pressures in the private sector and additional austerity measures despite austerity fatigue.
- Spain's central bank reported the nation's debt jumped to a record 88.2% of GDP in the first quarter of 2013. The year-over-year rise is Spain's fastest on record. As of the end of March, Spain's debt was up 19.1% from a year earlier, at €922.8 billion – all this debt with a 27.2% unemployment rate.25
- Over the past four years, Europe's economic problems have primarily been in the southern countries. After two quarters of negative economic growth, Finland is officially in a recession.26
- A euro/dollar exchange rate of 1.33 doesn't help corporate competitiveness at a time when European companies weren't competitive to begin with.27
Germany, however, remains the exception. The German consumer is in good financial shape and I would overweight companies that benefit from German retail sales, including the consumer discretionary and real estate sectors.
I would still focus on high dividend-paying European stocks, as the 4% dividend yield of the MSCI Europe Index looks extremely attractive with the 10-year German government bond yielding 1.51%.28
The Nikkei Index fell 6% on June 13 and is down 20% since the May 22 high of 15,627.29 The market decline began after Chairman Bernanke floated the idea of reducing the Fed's amount of monthly bond purchases at some point. The decline accelerated after Bank of Japan (BOJ) Governor Haruhiko Kuroda left a lending program unchanged, creating concern central bankers were becoming reluctant to add more stimulus. For a market addicted to QE, this potential withdrawal created panic for investors who have been trading the Japanese market.
The BOJ isn't reducing QE, it is just maintaining the current program – which is five times greater than that of the US, relative to GDP, and sufficient to purchase all government bond issuance this year with money left over.30
My view of the Japanese equity market hasn't wavered for a number of reasons:
- QE is likely to continue until Prime Minister Abe is up for reelection in 18 months or there is a spike in consumer inflation.
- The change in Japan's current account plus foreign direct investment flows, which since 1990 has had the best correlation fit, points to a fair value yen/dollar level of 120.31
- The unwinding of the carry trade – that is, selling a low interest rate currency to buy a high interest rate currency – should also help weaken the yen/dollar exchange rate.
- If the Nikkei's 96% historical correlation to the yen/dollar exchange rate holds, Japanese stocks are likely to trend higher when volatility subsides.32
Emerging markets: underweight
Declining commodity prices continue to drag down the MSCI Emerging Market Index. Europe's recession and low growth in the US has stifled demand for products manufactured in the emerging markets. Without further monetary stimulus from central banks in this region, stocks are likely to drift lower, providing investors with a better entry level in a region that I believe maintains some of the best growth rates, balance sheets and valuations in the world. Central bank stimulus may be delayed in countries like India, where the rupee has depreciated 10% in the past month.33 I don't know when the emerging equity markets are going to bottom, but if sentiment and capital outflows are any indication, we could be getting close.
The BOJ has embarked on the most aggressive QE program in history, and the equity market declined 20% when the BOJ governor said he has no plans to do more.1 QE in Japan is likely to continue until inflationary pressures become problematic. In the meantime, I believe Japanese stocks are likely to resume their uptrend as the yen/dollar exchange rate moves to 110 and possibly 120.
The Fed has expanded its balance sheet $450 billion so far this year.34 This is the fastest pace (45% annualized) since the recession ended in mid-2009.34 It is only prudent for Chairman Bernanke to slow the pace of QE – the direction of the target federal funds rate has not changed, just the rate of decline in the effective federal funds rate. With inflationary pressures declining, money velocity declining, the economy slowing and credit growth limited, I expect interest rates are likely to trade range-bound between 1.8% and 2.4% for the remainder of the year. The spike in volatility and recent weakness in equity prices provide another buying opportunity for dividend-paying stocks for the income investor.
The problems in Europe are not over, and I see calls for the end of its recession as premature. I don't see the advantage of buying European stocks early because they aren't that cheap. In Japan, I believe continued QE is likely to move equity prices higher once volatility declines. The MSCI Emerging Market Index tracks the direction of commodity prices, which tend to be cyclical. However, there are plenty of companies within this asset class that benefit from an increase in consumer spending. Investors should consider finding an exchange-traded fund (ETF) or actively managed emerging market fund that focuses on these companies. S&P 500 Index cash-adjusted valuations, the decline in the fiscal drag and the increase in consumers' disposable income are likely to keep the equity market moving to higher levels, despite an occasional pullback and/or market scare – like the one investors are currently experiencing.
The opinions referenced above are those of Richard Golod as of June 14, 2013, 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.
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