With global equities delivering negative returns in both nominal and real terms in the decades ending 2008 and 2009, the ‘death of equities’ was declared by segments of the media, causing intense scrutiny of the case for equity investment. Additionally, the scars left by two 50%+ falls in equity markets in the space of a decade together with the prospect of a period of anemic growth left equity sentiment at a generation low.
The great ‘normalisation’
While recovery has come hand in hand with risk, volatility and periods of disappointment, the bottoming of markets five years ago created the foundation for the most significant period of equity appreciation in a generation. With policymakers intensely focused on buying time for recovery via a heady cocktail of low interest rates and vast amounts of monetary stimulus, world stock markets posted huge gains. As improving economic data and a more optimistic earnings outlook provided a catalyst for the turn in equity markets, distressed equity market valuations have underpinned the magnitude of the rally to date.
Economic recovery led by the developed world
Although emerging market (EM) economies and stocks led the global recovery in 2009, economic improvement and rising sentiment has been firmly tilted toward the developed world since early 2012 as equity markets have staged a second surge. These signs of improvement followed a period of renewed skepticism in late 2011, creating the foundation for accelerating equity market returns as a ‘hope phase’ has slowly turned to the anticipation of a ‘growth phase’.
In contrast, economic growth in EMs has decelerated as China has aimed to engineer both a soft landing and a rebalancing of growth towards consumption within its economy, while natural resource rich nations have felt the impact of the end of the commodity super cycle. These trends have caused the EM growth premium over the developed world to narrow.
Will an improving global economic recovery lead to a recovery in corporate earnings?
Despite signs of economic recovery over the past two years, global earnings growth has been in shorter supply than many have recognised. Indeed, total global earnings per share (EPS) growth has been relatively flat over 2012 and 2013, with muted earnings growth contrasting with accelerating equity market optimism.
This earnings ‘plateau’ hides dispersed profits delivery across regions. EPS growth in the US has remained impressively consistent throughout both challenging and improving economic conditions. By contrast, European profits delivery has been weak with profits declining throughout much of the two-year equity bull market. Japan has experienced the most volatility in EPS growth: profits halved from June 2011 to June 2012 but have tripled from their low on export strength and given the leverage effect of a weak currency upon corporate profitability.
In aggregate, EM earnings have been falling for over the last two years, although this aggregate hides a large amount of dispersion by region. Asia has been an area of profits strength (indeed EPS reached an all-time high in 2013), while Latin America has proved a drag on profits, which has in tandem impinged on the core belief that EM companies are a source of superior profits growth.
US economic recovery to gain more traction
Key to further global economic recovery and global profits delivery is the pattern of growth for the US economy. The recovery thus far has been relatively anemic given the backdrop of accommodative policy action, but we do expect economic expansion to accelerate in 2014. One meaningful headwind to growth in 2013 was a fiscal drag of 1.0-1.5% of GDP pa, which will ease moving forward. This is partly in light of the fiscal deficit correcting rapidly as the economy has expanded and as government spending cuts and tax rises have made the desired contribution. Underlying trends in the private sector also indicate a healthy outlook, with unemployment still declining and with corporate and consumer deleveraging slowing. A broader-based continuation of these positive trends will sit at the heart of the US recovery maturing.
How will a strengthening economic cycle impact regional growth?
The pattern of improvement is not isolated to the US economy. Global industrial output indicators are encouraging and this should benefit more cyclical economies if the cycle does mature. Japan, one of the world’s most levered countries to an uptick in industrial production, has historically been the largest beneficiary of a global economic cycle. Meanwhile, although investors are clearly skeptical at present, EMs should also benefit. Asia is a notable area of opportunity, especially given current valuations.
Thus far, we have seen very few signs of cyclical optimism filtering across from the developed to the emerging world, primarily due to US Fed tapering absorbing so much of investors’ mindset. However, even with the slowdown in China a source of concern and with legitimate questions over how many EM countries with current account deficits will finance their future growth, we believe the EM story encapsulates an opportunity to benefit from secular and cyclical trends.
Valuations are still reasonable
Global equity valuations have moved far from the distressed levels seen at the beginning of 2012, but continue to remain reasonable in aggregate. Having seen the expansion of valuation multiples drive a large amount of equity returns over the past year, it is important to recognise that the future drivers of equity markets are now likely to evolve. A more even balance of return drivers spread amongst earnings growth, cash return from balance sheets, and more stock-specific multiple expansion may make for a more complex outlook, but one that will favour profits delivery as we move into the ‘growth phase’ for the global economy.
Emerging markets look particularly attractive
For those willing to look through near-term volatility and the slowdown in growth as stability-enhancing policy efforts are prioritised, valuations and elevated correlations suggest an opportunity is being created within the EM world. While selectivity is still required given the end of the commodity super-cycle and the evolution taking place within many EM economies, the pessimism surrounding EM stocks looks extreme and unusually uniform.
Where do we go from here?
We have enjoyed a remarkable period for equity investing since the global financial crisis and have seen both volatility and opportunity on an unprecedented scale. While the magnitude of equity markets returns over the past five years needs to be separated from today’s outlook, we believe that equities can deliver solid returns to investors over the next two to three years.
However, while we maintain an optimistic medium- to long-term outlook, we are concerned near term that uniform bullishness in the developed world is likely to contrast with the reality of the next stage of the cycle, especially as fundamentals remain highly dispersed. This will inevitably lead to increased volatility but importantly, opportunities to refresh stock positions as expectations adjust.
EMs continue to face intensely negative sentiment. While we agree that this skepticism is warranted in specific areas, there are numerous countries where the long-term fundamental outlook remains very strong.
Overall, corporate fundamentals are in good shape. With many opportunities remaining at the stock level and with equity valuations still reasonable, we believe with a focus on fundamentals there remain many opportunities for global equity investors.
Scott Berg is portfolio manager, global growth equity strategy, T. Rowe Price