Director, Global Investment Strategies
Statements from the heads of central banks across the globe helped move global
equity markets higher last month. I believe the recent rally may have created an
inflection point that could potentially limit the equity market's downside. That said,
the market's upside could also be constrained, at least in the near term, in my opinion.
This month's commentary provides some perspective on this environment for longterm
- Overweight US. Recent positive economic and market developments have probably
taken a third round of quantitative easing (QE3) off the table for now. I believe a
delay in additional easing could also delay the equity markets' continued advance
in the short run. Although improvements in the Economic Cycle Research Institute
(ECRI) Weekly Leading Index and the Citi Economic Surprise Index for G10 countries
would suggest adding additional risk to portfolios, this trading opportunity may be
too brief for investors to capitalize. Rather, I believe long-term investors should continue
to add high-quality, dividend-paying, large-cap companies to equity portfolios.
- Neutral weight Europe. Supportive statements from European Central Bank (ECB)
President Mario Draghi and German Chancellor Angela Merkel have propelled
European equity markets lately. Although I believe market lows could be behind us,
economic data and market sentiment indicators remain in decline. This warrants
continued defensiveness in European equities, in my view, with a focus on highquality,
dividend-paying, large-cap multinationals.
- Overweight emerging markets. The asset class is likely to remain out of favor
with investors until there is more clarity on the European debt crisis and enough
time elapses for any additional policy stimulus to work through the economies.
However, I believe emerging market equities still have one of the most attractive
risk-reward profiles for investors with the appropriate risk tolerance who are seeking
the potential for long-term growth.
The following pages expand on these insights and examine the implications for global equity investors.
Central banks helped sustain global equity rally
Global equity markets continued to rally into August as investors gained confidence
about central banks' intentions to address the global economic slowdown. Investors
believed ECB President Draghi reduced the "tail" risk — that is, an extreme level of risk
— in the eurozone after stating at the Global Investment Conference in London on July
26 that "the ECB is ready to do whatever it takes to preserve the euro." His comment
was reiterated by Chancellor Angela Merkel and French President Francois Hollande. In
August, US Federal Reserve Board Chairman Ben Bernanke intimated that additional
stimulus may be forthcoming if needed, and China's Premier Wen Jiabao said there is
"growing room for monetary policy operation."
As a result, global equities (as measured by the MSCI World Index) have rallied 12%
since the June 4 low, European stocks (as measured by the MSCI Europe Index) rallied
17% and the S&P 500 Index is up 10% as of Aug. 15.1
For US equities, the rally has reduced the extreme valuations (as measured by dividend
yield spread, the difference between the dividend yield on the S&P 500 Index and the
yield on 10-year Treasury bonds) and equity risk premium that existed in the S&P 500
Index in June. In addition, the rally has eased the level of pessimism among other
measures of investor sentiment, including the New York Stock Exchange's (NYSE)
short interest volume (as measured by the NYSE Short Interest Ratio) and the NYSE
With the recent rally, I believe investors may have seen an inflection point that could
potentially limit the equity market's downside. But is there more upside this year?
Although the S&P 500 Index has remained in an uptrend since the index crossed
above its 200-day moving average (an important technical level) on Dec. 19, 2011, it
wouldn't surprise me to see some profit taking in September as additional monetary
stimulus (QE3) seems less likely. The economy isn't weakening enough to announce
another round of easing any time soon, but it's also not strengthening enough to take
the possibility off the table, in my opinion.
Consider some of the positive economic announcements in recent months:
- Retail sales surprised on the upside in July with the first increase in four months,
reflecting broad-based gains and reducing concerns that the consumer will retrench.3
- After six years of negatively affecting gross domestic product (GDP) growth,
residential housing has contributed positively the past five quarters.4 The National
Association of Home Builders/Wells Fargo Housing Market Index, a measure of
homebuilders' sentiment, is at a five-year high as of its August reading.5
- US building permits jumped to their highest level in four years, suggesting that the
real estate and construction sector could remain strong throughout the remainder
of the year.6
- Job openings are at the highest level in four years.7
- Unemployment claims are the lowest in four months.8
- The ECRI Weekly Leading Index, while still slightly negative, has improved five
- The Citi Economic Surprise Index for G10 countries (at –19.70 on Aug. 17) has
been trending higher since the July 19 low of –65.10
However, not all economic announcements have been positive. Second-quarter
GDP growth came in below expectations. Consensus forecasts for GDP and earnings
continue to decline. Lastly, the recent increase in food and gas prices will likely
temper the increase in real disposable income.
Until investors gain a better sense of the direction of the economy and see reduced
tension in the Middle East and further progress in Europe, it wouldn't surprise me to
see the S&P 500 Index trade in a tight range for a couple of months. At current levels, I believe the Chicago Board Options Exchange Volatility Index (a measure of market
volatility known as the VIX) suggests the S&P 500 Index may struggle to move higher.
Therefore, although some recent data could support adding additional risk to portfolios,
I believe investors should remain defensive, opportunistic and selective. Investors should
continue to overweight high-quality, dividend-paying, large-cap stocks in the noncyclical
sectors, in my opinion.
Europe: neutral weight
The European equity markets (as measured by the MSCI Europe Index) rallied the past
10 weeks (as of Aug. 17) and are trading at the highest levels since March 2012. The
Euro Stoxx 50 Index, a measure of eurozone "blue chip" stocks, is up 19% since the
June 1 low, as of Aug. 17.11 Fueling these gains were factors such as UK retail sales
beating forecasts, German and French GDP exceeding expectations and hedge funds
covering short positions — a trading strategy employed when there is speculation that
the share price could rise — at the fastest pace in three years.12
That said, the eurozone economy contracted in the second quarter for the first time
- July was the sixth consecutive month that output in eurozone manufacturing and
- Germany, which accounts for roughly 27% of the euro area's output, has seen
slower growth in each of the past five quarters.15
- German business confidence (as measured by the Ifo Business Climate Index) fell to
the lowest point in two years in July.16
- The German ZEW Indicator of Economic Sentiment slipped in August to –25.5 from
–19.6, its third decline in a row.17
For the region as a whole, analysts have slashed profit forecasts at the fastest rate
since 2009, and 2012 consensus earnings estimates have been reduced to 5% from
19% at the beginning of the year.14
Economic and profit decline in Europe is not a surprise to anyone. In my opinion,
the primary drivers of the recent equity rally have been changes in the equity risk
premium, which were prompted by the comments from Mr. Draghi and Ms. Merkel,
and expectations for Spain to accept a bailout and for further austerity in Greece.
It has been my position that the euro will survive and euro leaders will step up when a
crisis insists on action, but only at the eleventh hour when the euro's survival depends
on it. I suspect the saga will continue in the eurozone, but the tail risk has likely been
taken off the table for now. The market lows could be behind us, in my opinion.
I believe investors with the appropriate risk profile should consider adding high-quality,
large-cap, dividend-paying European multinationals to equity portfolios.
Emerging markets: overweight
The MSCI Emerging Markets Index has continued to underperform the S&P 500 Index
year-to-date (as of Aug. 17).18 The BRIC (Brazil, Russia, India and China) economies
continue to feel the strain from problems in Europe and, in the case of Russia, lower
energy prices and rising inflation.
China's economic slowdown will likely extend to seven quarters as industrial production
and lending fell short of expectations, and export growth collapsed in July.19 Foreign
direct investment fell to the lowest level in two years.19
In June, India's PMI (purchasing managers index) fell to its lowest level in eight
months.20 However, inflation fell to a 32-month low in July, leaving room for additional
policy stimulus, which I believe could positively affect the equity markets.21
Brazilian equities rallied 12% from the June 1 low to Aug. 17 in anticipation of additional
policy stimulus in China, a major export market.22 However, economic data in
Brazil remain weak, with industrial production falling, disappointing exports and little
improvement in loan growth. It would appear the equity market is ahead of
Russia is going through a real estate boom, with housing prices up 18.2% (seasonally
adjusted) in the second quarter.23 This, in turn, has spurred consumer spending and
threatens to overheat the economy. Monetary policy is likely to remain in favor of
higher interest rates.
The fact is, according to research by Goldman Sachs, the global business cycle entered
a contraction phase in April and has remained there.24 I believe emerging market equities
are likely to continue to underperform in such an environment, especially when
investors are reducing risk assets in portfolios. Investors are unlikely to meaningfully
add to riskier assets such as emerging market equities until any additional policy stimulus
is given time to work through these economies and more progress is seen in Europe.
As mentioned in last month's commentary, relatively cheap emerging market equity
valuations have limited the downside.25 Additional policy stimulus is in the offing, in
my opinion, and could be constructive for higher equity prices. I believe investors with
the patience to hold emerging market equities for the long term should continue to
add to the asset class while it appears undervalued. I believe emerging market equities
still have one of the most attractive risk-reward profiles for investors with the appropriate
risk tolerance who are seeking the potential for long-term growth.
The global economy is growing at a paltry pace, but recent data announcements indicate
the slowdown may be behind us. If the Citi Economic Surprise Index and the ECRI
Weekly Leading Index continue to improve, these conditions could support a case for
higher equity prices and justify adding more risk assets to portfolios, in my opinion.
Although the global equity markets have been in an uptrend, I am concerned investors
could be temporarily disappointed by waning expectations for QE3, a lack of detail in
solving Europe's sovereign debt crisis and continued economic weakness in the emerging
markets. Therefore, I would forgo adding additional risk to portfolios and instead
remain opportunistic and selective and continue to add high-quality, large-cap, dividend-
paying, multinational stocks from around the world.
The opinions referenced above are those of Richard Golod as of August 17, 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.