by Norm Boersma

Stock Market

Are equity investors pushing the gas pedal too hard?

Are equity investors pushing the gas pedal too hard?
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Global equities advanced during the first several months of the year as investors weighed continued policy stimulus and solid corporate earnings results against anaemic economic data. Headline economic trends remained lackluster; 2.5% first quarter gross domestic product growth in the United States disappointed on government spending cuts, China’s 7.7% acceleration marked the longest stretch of sub-8% growth in two decades, and manufacturing and services in the eurozone showed further signs of weakness.

The eurozone remains a major cause of concern for global investors. As French political economist Jean Monnet, one of the chief architects of the European Union, noted early on: “Europe has never existed. It is not the addition of national sovereignties in a conclave which creates an entity; one must genuinely create Europe.”

The difficulties of doing just that have been on full display since the onset of the global financial crisis as economies with different fiscal positions, credit terms and labour market dynamics all seek stability under a unified currency and monetary regime. Yet, we believe the experiment has yielded considerable benefits as well. The euro area on the whole has the most sustainable fiscal position of any major Western region, with fiscal deficits falling to just 3.4% of GDP in 2012. This compares with 9.6% for Japan, 8.6% for the US and 6.3% for the United Kingdom.

Reforms in the periphery have been particularly encouraging. According to the Organisation for Economic Co-operation and Development (OCED), the four eurozone members that have had to ask for external support (Greece, Ireland, Portugal and Spain) are also the countries that have made the most progress with reforms over the past two years.

“The remainder of 2013 will be a critical period for Europe. While progress has been made and fiscal tightening is expected to ease, political risk remains high.”

The remainder of 2013 will be a critical period for Europe. While progress has been made and fiscal tightening is expected to ease, political risk remains high as evidenced by the growing backlash against austerity, reform in the periphery and increasing bailout fatigue in the core. However, European stocks have been aggressively discounting all this uncertainty.

On trend earnings multiples, some of the cheapest markets in the world are European. Europe remains one of the world’s largest export markets and its top-tier companies are prolific revenue generators, which we think could translate into sustained earnings growth, should European corporates begin to close the record profitability gap with their US counterparts. We believe macro uncertainty and political tail risks will likely keep European risk elevated, while selective investors should, in our view, find plenty of support in improving fundamentals, attractive valuations and accommodative central bank policy.

Economic reality and equity performance

In recent months, equities have continued to rally, decoupling from other cyclical assets such as commodities and, in the minds of some investors, from economic reality altogether.

Yet, it is important to remember that equity prices, unlike commodity prices, reflect the current value of presumptive future cash flows. The apparent disconnect between high absolute equity prices and low economic growth expectations distracts investors from a more critical consideration: the current market price of future corporate cash flows.

To this end, global equities are still trading at less than one standard deviation below their average normalised earnings multiple, a phenomenon that is not 'disconnected from reality', but consistent with investors’ lowered growth expectations. Meanwhile, equity risk premia (equity earnings yields minus risk-free bond rates) are historically elevated, reflecting the current climate of reluctance and uncertainty.

“On a normalised basis, then, stocks appear to be fully pricing in slower growth and higher risk, creating significant scope for multiple expansion in the unanticipated event of continued stabilisation or an eventual recovery in growth expectations. Against this backdrop, the defensive rally within equity markets thus far in 2013 seems rational. Defensive outperformance reflects downside risks to growth and stability, but the backdrop of overall equity strength suggests a growing awareness of the compelling value proposition of the asset class.  

Not only are normalised multiples historically low, but corporate balance sheets are historically strong, capital efficiency is improved and, in a zero-rate environment, global equities have been offering compelling dividend and free cash flow yields. Finally, central banks are as committed as ever to stimulus and liquidity provision. Risks remain, but seem largely discounted by current multiples.

Bottom-up opportunities in a top-down world

As always, considerable uncertainty remains. Policy tightening in China and what we regard as the inertia of sovereign indebtedness in the West could conspire to keep a lid on global economic growth in 2013. As in any era of 'financial repression', political risks can assume outsized significance.

Yet, we believe there are reasons for optimism as well. Fiscal drag aside, pockets of the US economy – including in housing, employment and private-sector demand – have shown continued improvements. Meanwhile, despite recessionary conditions in Europe, long-term leading indicators such as eurozone real M1 (a measure of money supply) and German business confidence may portend a return to growth in the not-so-distant future.

The recent political transition in China may also mark an economic inflection point as the country shifts away from a 'growth at all costs' mentality and toward the promotion of growth stability. Yet, even if growth disappoints, markets need not necessarily do the same.

Ultimately, we do not know what the future holds. As Sir John Templeton wrote, “I never ask if the market is going to go up or down because I don’t know – and besides, it doesn’t matter. I search nation after nation for stocks, asking: ‘Where is the one that is the lowest priced in relation to what I believe it’s worth?’”

In our view, this raises perhaps the most compelling cause for optimism: as of early May, global equities as a whole still traded at a significant discount to their long-term earnings multiples according to our analysis. As a result, we continue to find stocks around the world that are priced low in relation to what we believe they are worth. 

Norm Boersma, CFA, chief investment officer of Templeton Global Equity Group

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