The outlook for equities
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This morning in an interview I did with Reuters TV, the interviewer said that ‘if we mapped the markets, equities seem to have been the only asset class that’s been making money while bonds, cash & commodities had been lagging – and would this trend hold out in this year’? The interviewer also wondered if I saw ‘money flowing only into the US markets from here-on, or were there other markets which can give the same kind of returns’?
My reply was that the data clearly show that US equities have marginally outperformed bonds and corporate credit since the sell-off started in late May – and we believe that equities are likely to continue being the best performing major asset class.
The main reason we remain overweight in equities (with the year-end targets on the S&P 500 of c.1,725 for 2013 year-end and perhaps 1,900 for the end of 2014) is support from relative valuation. The forward looking US equity risk premium is around 5.6% even with quite cautious corporate earnings numbers, yet taking account of economic conditions and spreads, the warranted risk premium is perhaps 4.9%, and both these elevated levels compare with the long-run average of 3.2%. If we focus alternatively on equity valuations relative to corporate bonds, the corporate bond yield/corporate earnings yield gap suggests that equities have rarely been as attractive relative to corporate bonds. Of course higher bond yields can undermine the case for equities by affecting activity levels, debt costs and as an opportunity cost, but it looks that government bond yields only become problematic for equities when the 10-year US bond yield rises to 3.25%, so there’s quite some room yet.
As for investor positioning, long-run investors’ equity weightings are close to the bottom end of the 50-year range and since 2008, global bond funds have seen around $1.3tn of inflows, compared to $300bn of outflows for global equity funds, according to the EPFR data. Equally equities should be supported by excess liquidity, with OECD M1 supply relative to global nominal GDP still rising at 6% p.a., which is broadly consistent with an on-going re-rating of equities. What’s more, developed market central bank balance sheets are set to expand by around 20% by the end of next year.
There are risks of course associated with inflexion points in central bank policy, but the real risks look to be associated with the first rate rise, as in February 1994, or a change in language by the Fed, as in late January 2004. These look to be risks that may be pushed out as far as 2015, whilst the market now appears to anticipate that the first Fed rate hike will be in November 2014. This looks too early given that the 6.5% unemployment threshold is unlikely to be breached until 2015, with the rate of growth of the labour force likely to pick up to between 0.75% and 1%, and, on balance, the low level of inflation suggests that the Fed could allow unemployment to fall to 6% before it raises rates. Additionally, both the ECB and MPC have explicitly repudiated any near term shift in policy.
Whilst inflation pressures remain modest, there are clear signs of an improvement in global economic momentum, and ordinarily this is good for equities, supporting an improvement in earnings momentum and corporate margins need not fall until labour has pricing power, which looks unlikely to be achieved in the near term. For what it’s worth, historically, equity markets have not peaked until on average two years after the peak in margins.
There are also some tactical reasons to be bullish equities – with scope for risk appetite to rise. As for which market will outperform, the better point of focus should be on company specifics, with many corporates continuing to offer excellent growth credentials at low valuations with strong free cash flow and robust balance sheets. Where such companies are quoted seems remarkably unimportant in this age of globalisation and open borders – who’d have guessed (without knowing) that nearly half of FTSE 100 dividends are now actually paid in US dollars!
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
