Published on Apr 28, 2013
Global economy is growing but not so strongly as to trigger a turning point yet
By Lim Say Boon
Global equities have more than doubled since the lows of the global financial crisis and key US stock indexes have broken historical highs. Notwithstanding the market's predictable "fear of heights" and the likelihood of a correction, we are staying overweight on equities.
Conditions continue to favour risk asset markets:
The global economy is growing despite pockets of weakness;
Corporate earnings growth will likely sustain higher stock prices;
Valuations are still moderate;
Negative real interest rates and government bond yields and the yield gap between equities earnings and government securities favour stocks;
Continued growth in global excess liquidity;
Economic conditions are not robust enough yet for central bankers to tighten monetary conditions in developed economies; and
Central bankers have committed themselves as lenders of last resort in the US, euro area and Japan, hence containing periodic bouts of fear related to the twin dysfunctions of debt and deficit in these economies.
The preoccupation with US indexes trading above historical highs is superficial. It tells us nothing about the underlying index earnings and, therefore, valuations. And it says nothing about broader economic dynamics driving the global search for yields.
That the S&P 500 has broken its historical high is not surprising. The index's adjusted operating earnings per share broke its own historical high 18 months ago. (See chart) And because of this earnings growth, US equities' price-to-earnings valuations are still at the middle of its cyclical range despite prices more than doubling from early 2009.
Taking an even longer view, in January 2000 - when the S&P 500 was also trading at around the levels of today - the operating earnings per share was only about half what it is today. In short, the market is today only paying about the same nominal price for almost double the earnings of early 2000.
Monetary conditions are also very different today compared to the earlier peaks recorded in early 2000 and late 2007 - they are more supportive of even higher valuations than during those two earlier periods. In early 2000, the 10-year US Treasury yield peaked at 6.8 per cent and the Fed policy rate stood at 6.5 per cent. In late 2007, they were 5 per cent and 5.25 per cent respectively. These compare with only 1.85 per cent and 0.25 per cent today.
Indeed, monetary conditions continue to pressure investors out of cash and bonds. Fears of the US Federal Reserve staging an earlier-than-expected exit from quantitative easing have faded. There is insufficient evidence of strong, self-sustaining economic growth to justify the Fed pulling back on asset purchases any time over the course of this year, much less raising its policy rate.
Unemployment at 7.7 per cent is still a long way from the Fed's 6.5 per cent condition for an end to its "exceptionally low" policy rate. And inflation remains significantly below the 2.5 per cent that would cause the Fed concern. Meanwhile, given programmed government spending cuts and near zero interest rates, quantitative easing remains one of very few policy tools left. Ultra-low rates and quantitative easing are likely to continue through the course of this year.
Indeed, at the global level, excess liquidity - defined as the growth of money supply in excess of economic growth - is likely to pick up again as the Bank of Japan accelerates quantitative easing and as the European Central Bank activates its Outright Monetary Transactions programme.
At some point in the growth cycle, when inflation becomes a greater concern, the cyclical uptrend in equities will end. But we are not at that point yet. The global economy is growing but not so strongly as to trigger a turning point in global monetary conditions. The International Monetary Fund is forecasting 3.5 per cent GDP growth for the global economy, slightly firmer than 3.2 per cent for last year.
Meanwhile, moderately higher inflationary expectations have historically tended to support equities. It is not inflation that ends equities rallies but monetary tightening.
And so in Asia ex-Japan, it has been the fear of monetary tightening that has been driving the recent underperformance of equities in Greater China. But broad policy tightening is unlikely at this stage. The focus has been on administrative controls, particularly in the property sector.
In any event, the growth of instruments such as so-called "wealth management products" and "trust loans" should supplement bank credit, making loans growth ceilings less meaningful in China.
Meanwhile, the Chinese economy is likely to soon confirm that it is picking up the growth momentum from the fourth quarter of last year, with fixed asset investment likely to again lead growth.
Valuations for Chinese equities - both in Shanghai and Hong Kong - have dipped again after a brief upturn. They are now back at global financial crisis lows. At these levels, the downside is likely to be limited. We would be buying on the ongoing correction.
Bonds remain poor value relative to equities. And they are likely to continue their lacklustre performance from the start of the year. Total returns for the JP Morgan Global Aggregate Bond Index have been marginally negative for the year. Reflecting the gradual recovery in the US economy, the 10-year US Treasury yield has been edging up since the start of the year.
Meanwhile, for Asia ex-Japan credits, total returns year to date have been flat. And at current valuations, further spread tightening will likely be modest. Indeed, supply risk could result in some spread widening, particularly if there is another risk-off episode driving fund outflows.
But the "Great Rotation" out of fixed income into equities is still not imminent and a collapse of the bond market is unlikely as long as interest rates remain low and risk-averse liquidity stays flush.
Commodities should generally do better this quarter on firming global growth, a weaker US dollar, and easing fears surrounding China's economic transition.
The divergence between stronger equities indexes and stagnant-to- weaker commodity prices over the past quarter has been a disappointment.
Industrial metals corrected in the latter half of the quarter after a rally in January and early February. And much of this underperformance boils down to market concerns over China's new economic growth model and, more immediately, the possibility of broad monetary tightening. Longer-term, there are uncertainties over the extent to which Beijing's economic rebalancing from fixed asset investment towards consumption would slow its demand for commodities.
While there is some basis for these concerns, they appear exaggerated. Consumption expenditure accounts for little over a third of China's gross domestic product. The overwhelming driver of China's economy is fixed asset investment. Rebalancing towards consumption will be a multi-year project.
Meanwhile, the Chinese government cannot afford for economic and social reasons to crack down too hard on either credit or investment growth.
So it will apply administrative controls over the private property sector but, at the same time, it will expand social housing construction as an offset. The Chinese central bank will maintain vigilance over money supply and bank credit growth. But it will allow non-bank sources of credit - through instruments such as wealth management products and trust loans - to continue to fund investments.
The central bank will likely maintain a neutral stance over the coming months, as long as inflation remains below its tolerance threshold of 3.5 per cent.
Over the coming months, economic data coming out from China will likely confirm a GDP growth momentum of around 8.5 per cent year-on-year and over 20 per cent expansion in fixed asset investment. At current prices, industrial metals have likely exaggerated the risk to China's growth.
A likely correction in the US dollar index, DXY, in the second quarter of this year will also help commodities, given the negative correlation between the two.
The writer is chief investment officer, Group Wealth Management and Private Bank, DBS Bank