We have come a long way since stock markets reached their crisis level lows in early March 2009. In fact, since those dark days, the JSE Top 40 has delivered a total return of 200 percent, whilst the MSCI All Country World Index has been almost as impressive, advancing 150 percent (both measured in US dollar terms from their lows through to end October 2013). With such an extraordinary recovery already achieved, it would be understandable if some investors are wary of investing at current market levels, believing perhaps that they have “missed the boat” on equities.
This article aims to determine whether such a view is justified, focusing on the global equity market as a test case. In doing so, investors need to put aside any regrets they harbour over opportunities that have now passed, and instead re-examine the fundamentals of potential earnings growth, current valuations and risk.
All the indications are that the global economic picture is brightening. Indeed, we would argue that it is likely that the improvement in activity will continue to build into 2014, and beyond. After all its trials and tribulations, the global economy is operating well below its normal capacity (most notably in Europe) and, notwithstanding the headwinds of a debt hangover and continued austerity, coming off such a low base, it has the potential to grow at a reasonable pace for a number of years.
However, when we buy equities, we are not investing in economies, but in companies. While the macro background has an important influence on the outcome, what really matters is the progression of corporate earnings. So, with that in mind, what can we say about the outlook for global corporate earnings growth over the next few years? Well, it seems corporate earnings around the world are also running somewhat below normal levels (especially outside the United States). Just like the economy, global companies have stored up potential to produce a period of improving earnings growth as we move through the next few years. We can see this in Chart 1 below, where we present the long-term reported earnings data (and the trend line) for the MSCI All Country World Index.
The potential for accelerated earnings growth exists, in part, because the European economy is only just coming out of a deep recession, and also because some very big sectors, such as banking and commodities have been having a tough time over the past few years, reporting earnings that are well below normal. Moving forward, the negative influence of many of the issues that have held profits down will fade, and earnings could grow at double digit rates for a few years. According to IBES, who maintain a large database of analyst forecasts for company earnings, the consensus is that global corporates will grow their profits by 10 percent on average in both 2014 and 2015.
Chart 2 below shows a simple long-run price to earnings ratio for the “global stock market”, again using data sourced from MSCI. As the most commonly used valuation yardstick, the current price to earnings ratio of 16.8 times historic earnings compares favourably with its long run average. When earnings are far away from trend, the price to earnings ratio can be a misleading valuation indicator, because it will be based on profits that are either unsustainably high, or abnormally low. However, we believe that given current profits are a little below normal, the latest price earnings ratio is sending us a reasonably reliable (if slightly unflattering) signal.
What about risk?
This is perhaps the hardest to quantify. There was a time when the foundation for thinking about risk in financial markets was international government bond yields, to which financial analysts would add risk premia to create yardsticks to help them assess fair valuations for other asset classes, such as equities. With interest rates and long bond yields pinned to the floor by extraordinary central bank policy actions, international government bond yields have now become a distorted, and arguably, worthless reference point. So while the relative valuation of equities to bonds strongly favours equities, quite a bit of this reflects the fact that bonds are overvalued on any reasonable measure.
That said, in our view, it is likely that financial repression (in the form of very low interest rates) is likely to stay in place for some time to come, as central banks continue to lean against the disinflationary forces that still exist in the overly indebted developed economies. Why? Because if international interest rates were set at a more normal 4 to 5 percent, developed economies would go straight back into deep recession!
For that reason, we feel it is likely that the key central banks will broadly maintain their current interest rate policies for some time yet, providing a solid floor to global equity markets, whilst forcing investors to continue to abandon their “safe haven” deposit accounts and government bond investments in favour of real assets that offer better growth and valuations... like equities.
Equity markets are always subject to shocks as they journey through time. Indeed, the established pattern over the last couple of years has been that market advancement has been a somewhat erratic affair, with two steps forward often being followed by one step back. As the price earnings ratio has risen, arguably, the easy money has now been made in equities, and any progress from here is likely to be more pedestrian, as it will need to increasingly rely on earnings growth, rather than price earnings multiple expansion.
However, as things stand, and for the reasons given, we do not believe global equities are overvalued, and based on our assessment of current price to earnings, potential growth, and the ongoing actions of central banks, we would argue that it is not too late for committed investors to be thinking about allocating towards the asset class.
Andrew Yeadon is Head of Investments at Nedgroup Investments (London)