The earnings season began on Monday in the US and should once again show that companies in developed markets are capable of generating sustained, solid earnings even in an environment of modest economic growth and comparatively subdued credit expansion. In addition, in Japan and the US, earnings have reached or surpassed the previous growth cycle’s peak level, while stock prices and valuations still lag behind, which in turn helps drive gains in these markets…
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Mikio Kumada, Global Strategist at LGT Capital Management
Modest growth and overestimated emerging markets
The world economy has been growing at a very modest pace since the global financial crisis of 2007-2008. Western banks, like their Japanese counterparts a few years earlier, were primarily focused on identifying and writing-off bad debts of the recent past – a process that depresses lending and economic activity. Furthermore, with unemployment soaring in the wake of the “subprime” debacle in America and the “euro crisis” in Europe, Western consumption has remained comparatively subdued, while Japan had to cope with natural and environmental disasters of almost biblical dimensions after March 2011 – in addition to its chronic domestic deflation problem. And last but not least, the hope that consumers in Asia and other emerging economies would step-in to close the demand gap to keep the global economy humming has only partly been fulfilled. Instead, many of the emerging economies are now facing credit-related problems of their own.
Developed market businesses have outperformed the economy
However, developed market companies have in recent years consistently shown that they are able to generate decent returns in this muted environment. This contrasted with the disappointing performance of many emerging market businesses, which in some cases proved too reliant on excessive credit and/or cyclical/speculative tailwinds, such as rapidly rising commodity and/or property prices – dependencies that are not sustainable in an age of modest global growth. The earnings season for the second quarter of 2013, which began this week, should confirm these developments once again. In addition, consensus profit forecasts for the developed markets have been consistently too low in recent years, and remain conservative (forecasts for the US have been steadily cut over the past month, for example). This suggests that equity valuations in the old industrialized countries are probably even lower than they appear, because price-earnings ratios are of course based on consensus estimates. Finally, the reserve is true for many companies in the “growth markets”, where the trend in recent years has been to overestimate earnings.
Equity valuations remain attractive and imply potentially significant gains in the future
Let us look at the US market, to highlight the market’s potential. The S&P 500 is now trading just 15 times consensus earnings, with the average since 1954 at 16.3, and since 1995 at 21.1. Assuming the consensus is broadly right, a gain of about 12% by the end of 2014 would be justifiable even if market sentiment remains unchanged (i.e. the PE ratio stays at 15). Should sentiment improve and valuations move toward their long-term averages, a gain in the S&P 500 of up to almost 50% would not be abnormal at all. Similar cases can be made for Western Europe and Japan, with the only difference being that the potential upside of these markets in a “normalization” scenario is much bigger.
Rising long-term interest rates may even act economically stimulating
In other words, valuations remain attractive and provide a buffer in the event that the global economy disappoints in coming months. However, the latter scenario is not backed by the recent macro data. Leading economic indicators remain positive in the US and have brightened considerably in Japan; while key lagging data sets have improved as well (e.g. US labor market statistics). Even in Europe, the intensity of the recession is now retreating. Lastly, fears that the recent rise in US long-term bond yields could choke the economy still seem exaggerated in our view. Firstly, despite recent gains, long-term US interest rates remain very low compared to the level that would seem appropriate based on the current economic situation. Secondly, expectations of sustained gains in interest rates (just like inflation expectations) can prompt consumers and businesses to bring forward consumption and investment. Thus, they could ultimately prove more economically “stimulating” than the anticipation of quasi-eternal near-zero interest rates.
Equity valuations and earnings warrant further – potentially significant – gains
The price-earnings ratio (PE) represents what investors are willing to pay for a stock – it is ultimately a sentiment indicator. For the S&P 500, the consensus currently expects full-year earnings per share (EPS) of $110.2, which puts the PE ratio at 15, or about 10% below the average since 1954 and 32% below the average since 1995. If sentiment was more bullish, higher share prices would not be historically abnormal even if earnings were to stagnate going forward. Should estimates prove too low, as they consistently have since 2009, then higher prices would be justified even if investor sentiment remains at current levels. For example, if actual EPS come in 10% higher than expected, the S&P 500 should also rise by 10% as well – all other things being equal. Furthermore, assuming consensus estimates will prove broadly accurate and a gradual “normalization” of market sentiment (i.e. PE moving up towards historical averages), then the S&P 500 should trade between 12% and 47% higher by the end of 2014. In any case, as long as the global economy avoids a sharp recession in the near future, expectation-based valuations of companies remain clearly supportive for equities, especially in the developed markets.
US interest rates are still at historically very low levels
Over the long term, bond yields compensate for inflation, as well as general economic and debtor-specific risks. In the short to medium term, however, they can deviate significantly from that “appropriate” level, due to economic policy (as is the case now), or other extraordinary developments (like the 2007-2008 financial crisis). The “appropriate” yield an be approximated at any given time by adding real gross domestic product growth (1.8% in the US last quarter) to the inflation rate (1.4% in May). That puts the present “appropriate” yield at about 3.2%. The ten-year US Treasury yield, meanwhile, currently stands at about 2.7%, or 0.5 percentage points below that “appropriate” level (and shorter maturities are even lower). As graph (PDF page 2, “US 10YR Treasury Yield Gap”) shows, the gap between the actual and “appropriate” yield is not as extreme as in early 2012, but still very big by historical standards.
Source: ETFWorld – LGT Capital Management
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