What price should we pay for equities following the market gains in recent years? As ever, this is a difficult question to answer exactly, but any answer has to reflect the fact that valuations have risen considerably over this period. The implication of higher price to earnings ratios is that future profit growth prospects and the volatility of such growth should have improved considerably. It is this implication that markets are now trying to address and to resolve whether growth is indeed occurring, or in fact equity prices are just elevated by the ultra easy monetary conditions that are a result of quantitative easing (QE).
The growth outlook for the global economy remains patchy and to a large extent is tied to the propensity of the private sector to invest. In some regions, business confidence is higher due to recent growth, cheap financing and pent-up demand. Whilst the US and the UK appear closest to this scenario, it is lacklustre elsewhere. Household consumption also continues to be constrained by subdued wage growth, as IT-driven productivity, substitution from robotics, fewer full-time contracts and import competition all limit labour's share of GDP.
The United States is at the vanguard of current growth optimism with the desire of the Federal Reserve (the Fed) to normalise policy, encouraging speculation of higher interest rates. The growth trajectory to date however is superior to most other major developed economies and this has encouraged us to seek out companies that will benefit from the improvement in domestic economic activity. However, this stronger growth trend, the resulting lower probability of future quantitative easing and the increase in the onshore energy production, as a result of innovation, may have unintended consequences.
The first consequence is that stability in the Fed's balance sheet is making the US dollar (USD) a more attractive haven for capital than other currencies, where monetary debasement has yet to achieve economic traction. The resulting rise in the USD is also now having significant implications for companies and countries that have availed themselves of offshore issued USD-denominated debt. Where domestic currencies have fallen, this debt has become more expensive and hence there is an increasing desire to reduce this burden. The result of this is a cycle of capital flight and often also further currency weakness which can result in a self-fulfilling negative spiral. Various emerging markets are now exhibiting these characteristics.
The second consequence is commodities are under pressure, with the shift in growth leadership in China to consumption rather than investment being a clear contributory factor. This has also included the energy sector, where high US production and shifting agendas within the Middle East have engendered a battle for market share and a collapse in oil prices. This is now widely recognised by the market, but the implications for the corporate debt markets, and indeed also individual countries, are tension points that we continue to watch closely.
Europe, however, remains less clear cut. The region's equities look appealing in aggregate — particularly relative to the US — but the devil is in the detail. Much of this 'value' remains trapped in sectors with excess supply — reliant upon a meaningful pick up in global trade to yield the profits forecast by analysts in coming years. Whether this eventuates appears to be an open question at this point. At the other end of the valuation spectrum, many of the region’s better quality businesses — those that have delivered resilient growth during the EU's crisis of confidence — continue to command a multiple very similar to their US equivalents. A stock-specific strategy is therefore essential in European equities.
On the policy front in Emerging Market (EM) economies there have been improvements made since the last EM crisis, particularly in the areas of fiscal accounts and foreign exchange. However, there are pronounced pressures on some of these economies. In particular, the amount of credit taken out by the private sector in China, Brazil, Indonesia and Thailand is of concern. There is no doubt that US dollar (USD) appreciation has not been helpful and a lower rate of appreciation should give some emerging market economies a chance to reform. If that opportunity is wasted, it is difficult to see how this credit boom will not end badly once again.
The conclusion we take from the above trends is that growth within the key developed economies will continue, but will remain subdued by historical standards, both in real and nominal terms. When combined with prevailing valuation levels, the returns from equities are therefore much more dependent on the ability of individual companies to deliver higher growth through market share gains, innovation, or by exposure to geographies with greater growth prospects. In industries more exposed to the deflationary bun fight for market share (in general most commodities and traded goods), where currency devaluation is a common weapon of choice, selectivity has become even more paramount.
In summary, this would appear to not be a normal cycle, something that should not surprise investors when they consider that markets and economies are still being dictated to by unprecedented levels of monetary stimulus. Therefore, assuming that equity exposure is best achieved through a wide breadth of exposure (index investing) or based on assumptions that certain styles of investing will slavishly follow patterns that prevailed prior to QE, is debateable in our view. Instead, building a portfolio of companies that are more likely to flourish in the growth environment beyond 2015 is, we believe, a more worthy strategy.