Director of Global Investment Strategies
Global equities continued their upward trek in April. The regions with the most aggressive monetary policy generated the best performance. Sectors with high dividend yields also outperformed. Low global interest rates are motivating central banks to buy dividend-paying equities. I believe retail investors should consider doing the same.
- Overweight US. The economy is slowing, but the slowdown appears temporary. Investor sentiment is high but not euphoric. Valuations are higher, but equities still look undervalued on a cash-adjusted, price-earnings basis. In the early days of May, cyclical stocks were outperforming and I believe they are likely to continue to do so in the short run. That said, the defensive sectors look as though they're consolidating within a long-term uptrend after very strong first-quarter outperformance. Investors should overweight value stocks over growth stocks, in my opinion. At this point of the business cycle, value tends to outperform. Value stocks also tend to generate higher dividend yields than growth stocks.
- Underweight Europe. European stocks rallied on the anticipation of a central bank rate cut, which occurred on May 2. Declines in European credit default swaps indicate the region is becoming less risky, which tends to move equity prices higher. The recession continues in the region, with Germany being the exception. Investors should consider being underweight the region and be selective, focusing on high-dividend-paying value stocks.
- Overweight Japan. The aggressive quantitative easing (QE) program is likely to continue until the next election, some 18 months from now. The magnitude of QE is likely to continue to weaken the yen/dollar exchange rate. The historically high correlation between the yen/dollar exchange rate and the Nikkei 225 Index is the key reason to overweight this region of the world, in my view.
- Neutral to underweight emerging markets. The weakness in commodity prices mostly explains why emerging market equities have underperformed. A slowing global economy, especially in Europe, has also contributed to this region's poor performance year to date. However, emerging markets still have the highest economic growth rates, fastest growing consumer base and strong balance sheets at the fiscal, corporate and consumer levels. I believe investors already invested in this region should hold their positions.
The following expands on these insights and examines implications for global equity investors.
Central banks continue to drive equity markets
Global stocks rose 2.6% in April despite weaker macro data. Japanese equities increased 8.7% during the same time frame and have outperformed the MSCI All Country World Index equity markets for six consecutive months.1 European stocks came in second place last month, up 3.6%, on the back of strong financials sector performance.1 US equities rose 1.9%, and emerging market stocks posted positive returns of +0.4%.1 Global, Japanese, European, US and emerging markets stocks are represented by the MSCI All Country World Index, MSCI Japan Index, MSCI Europe Index, MSCI USA Index and MSCI Emerging Markets Index, respectively.
Yield continues to rule the day! At the global sector level, investors continued to focus on the defensive sectors in April—namely, utilities, health care and telecommunication services. The financials sector also outperformed most sectors in April.1
That said, in April, the JPMorgan Global Manufacturing PMI (Purchasing Managers Index) fell the most in nine months, declining 0.7%. Although the index is still above 50, indicating the world economy is still expanding, it was the weakest reading of the year.2 The Organisation for Economic Cooperation and Development (OECD) Composite Leading Indicator for the G7 countries has improved but remains in negative territory, suggesting the global economy may be headed for a temporary soft patch.
In a perverse way, investors are betting weaker global growth will ensure a longer period of accommodative monetary policy from central banks around the world and possibly even more aggressive action. As of May 9, we have seen 511 central bank rate cuts since June 2007, as countries from South Korea to Poland made additional rate cuts. Global monetary policy should be good for risk assets, such as equities.
Supporting continued monetary accommodation is the decline in inflation as commodity and energy prices have fallen. Globally, inflation peaked in 2011 and has since steadily fallen in both the developed and emerging markets. Since 1996, inflation has averaged 3.1% globally, 1.9% in the developed countries and 6.6% in the emerging markets. As of March, inflation was 2.2% globally, 1.3% in the developed world and 4.0% in the emerging markets.5
Slower global growth and lower inflation have brought interest rates down and equity prices up ─ with some markets reaching all-time highs. With many countries' PMIs on the cusp of expansion/contraction territory, can equity prices continue to move higher?
Investor sentiment is currently high:
- In the Thomson Reuters/University of Michigan consumer sentiment survey, 54.5% of respondents believe the stock market will be higher in the next year.
- Cash relative to margin debt at brokerage houses is lower than it was in 2007 or 2011. Leverage, measured by New York Stock Exchange (NYSE) Margin Debt (the amount of borrowing to buy US stocks on the NYSE), increased to $380 billion as of March, a 28.3% year-on-year gain and just below the $381 billion high in July 2007. In both 2007 and 2000, NYSE Margin Debt peaked prior to the S&P 500 Index peaking.8
- The Market Vane Index, a measure of investor bullishness, is at the high end of the range over the past seven years, at 67%.6
- The percentage of bullish retail investors has doubled to 40% over the past few weeks.
These levels would be understandable if the economy were improving. But the economy is slowing and will likely remain sluggish. Consider these indicators:
- Consensus second quarter gross domestic product (GDP) growth is expected to be 1.6%. The Conference Board's Composite Index of Coincident Indicators has declined two of the past three months (as of March). Since 1960, such a rapid contraction has led to a recession 100% of the time.11 The Conference Board's Coincident to Lagging Ratio, below 90, is also at levels that led to a recession 100% of the time since 1960.12
- More people are working, but total income isn't rising. It appears as though employers are hiring more people but cutting hours. The average workweek contracted in March and April.1313
- Housing, one of the bright spots in the economy, is returning to its old ways. Up to 20% of originated mortgages have down payments of less than 10%. Auto sales, another bright spot for the economy, saw subprime auto credit rise 30% from a year ago.15
The economy appears to be slowing just as sequestration is expected to slash income over the coming two quarters. That said, some of the economic weakness in March and April was due to inclement weather. In April, 96,000 people couldn't make it into work (almost twice the levels a year ago), which could impact retail sales figures, hours worked, housing starts and a host of other economic data points.16
Consumer sentiment is higher, but retail investors are still plowing more money into fixed income funds over equity funds. Domestic equity fund managers have continued to raise cash positions since the rally began — from $133 billion in Decem-ber 2012 to $156 billion in January, $162 billion in February and $166 billion in March.7 The percentage of bullish investors may have doubled, but levels remain well below extreme readings that would indicate investor euphoria.9
Measuring the positives and negatives, I am less bullish but bullish nonetheless. As investors become less scared, fundamentals will matter more. The decline in investors' fear has been transmitted to the price-earnings multiple (PE), which is now at 15.97 times for the S&P 500 Index, which is still below the 25-year average of 16.7.18 I believe further improvement in housing, unemployment claims, the federal deficit and implied earnings could take the equity market to higher levels.
Fundamental investors are worried about earnings slowing and/or not meeting expectations. Earnings are slowing because cash accounts for roughly 26.1% of the total market capitalization of the S&P 500 Index, which is earning next to nothing.19 So, what are investors getting for their money? They're getting stocks 15% cheaper than their long-term average on a cash-adjusted basis. The cash-adjusted PE subtracts cash from the total market capitalization and also subtracts nonoperating income from earnings. On April 30, the cash-adjusted PE was 13.1 times versus the long-term average of 15.4 times.19 If investors were willing to pay the same price multiple as the long-term average, the S&P 500 Index would trade at 1878.20
In the early days of May, sectors usually associated with a cyclical recovery were outperforming. Factors like beta and leverage are also confirming the risk-on trade (a trading environment that strongly favors higher-risk assets) is back. However, the relative valuation between low-quality stocks and high-quality stocks is near an all-time high. I believe the defensive sectors are consolidating within a longer-term uptrend.
I continue to favor stocks with dividend yields higher than the yields on fixed income. Furthermore, at this stage of the business cycle, I believe value stocks may continue to outperform growth for a couple of reasons:
- The likely continued outperformance of the financials sector.
- The value style classification has a higher percentage of companies that derive the bulk of their earnings from domestic operations, which makes them less influenced by the recent and likely ongoing strength in the dollar.
High-yield corporate bond yields traded below 5% for the first time in history last month.21 The lower the yields on fixed income, the more attractive stocks will become. By keeping interest rates low(er), central banks are giving investors a yield alternative – equities. Investors should consider taking it while valuations are still attractive. The relative risk/reward no longer favors fixed income, in my opinion.
European equity markets also have been responding positively to monetary stimulus. On May 2, the European Central Bank (ECB) lowered its key interest rate from 0.75% to 0.50% in a much-anticipated move to address the ongoing recession in the region. The equity markets had been moving higher on the anticipated rate cut. Declines in European credit default swap prices indicate the region has become a safer place to invest. As a result, the equity risk premium has fallen, which has also helped move stock prices higher.
ECB President Mario Draghi has successfully completed phase I: reduce/remove the odds of a financial crisis. Phase II – pass legislation that promotes growth within the region – will potentially be more difficult. In the meantime, German industrial production has increased two consecutive months, and earnings surprised on the upside.23
My reason for underweighting the region is based on the bifurcation of valuations. The high-quality stocks are not cheap, and earnings in the lower-quality stocks are questionable. I'm still not convinced the banks have fully recovered in less than two years. The market has most likely already priced in the rate cut. However, the region is beginning to look more attractive as more countries back away from their severe austerity measures, which could potentially lead to economic growth surprising to the upside. I would rethink my position on the eurozone if the currency were to weaken more. What I do like in the region are stocks with yield, which currently average more than 4% (based on the MSCI Europe Index).24
The investment opportunity in Japan is pretty simple. The head of the Bank of Japan has implemented a very aggressive QE program, which, based on GDP, is five times greater than US monetary policy.25 QE will likely continue until Prime Minister Abe is up for reelection in 18 months. The Nikkei Index is 96% correlated to the yen/dollar exchange rate, which is likely to decline further.26 I would continue to focus on large-cap exporters, despite their recent run-up.
Emerging markets: underweight
Emerging equity markets managed to eke out a positive return last month, but they continue to underperform the developed markets. That is somewhat to be expected, considering the current weakness in commodity prices. An interesting note — compared with the US, Japan and Europe, emerging markets is the only region where government bonds have outperformed equities year to date.27
China is affected by the recession in Europe. Brazil's economy is struggling because of a lack of growth. Its central bank is hesitant to lower rates more aggressively to promote growth because of inflation concerns. Eastern Europe is suffering from the recession in Europe, and Russia is negatively affected by the decline in oil prices.
As mentioned in last month's commentary, I believe investors who own emerging markets should continue to hold. New money allocated to the region should wait for either a weaker dollar or stronger global growth data. Investors should also consider focusing on domestic names that benefit from domestic demand instead of exporters. However, if macro data are correct and the global slowdown is temporary, it is just a matter of time before this asset class could potentially outperform developed markets. For now, investors may want to focus their attention elsewhere for better near-term opportunities.
The US equity market appears overbought, but not at record levels. Investors are more bullish, but not euphoric. Valuations are higher, but not extreme. Earnings growth is slowing, but not negative. When the yield on stocks is higher than the yield on government bonds, equities tend to outperform.
Central bank liquidity, which is rising, provides a floor for the equity markets, rewards risk assets like equities and will likely continue until the world economies improve. If central banks, which hold $11 trillion in foreign-exchange reserves, are buying stocks in record amounts, individual investors should probably take note. Central banks, sovereign wealth funds and countries, including Japan, are likely to buy liquid stocks they know.
I would expect the big blue chip stocks paying dividends to outperform their peers. Investors should overweight value over growth and large-cap over small-cap, in my opinion. There are few times in history when investors get this type of risk/reward opportunity. Take it!
The opinions referenced above are those of Richard Golod as of May 15, 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.
All investing involves risk including the risk of loss. Diversification does not eliminate this risk. The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues. 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. A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets. Junk bonds involve a greater risk of default or price changes due to changes in the issuer's credit quality.
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