International outlook (commentary for the fourth quarter of 2012)
01 February 2013 - Tony Gibson
Global equity markets rallied in the fourth quarter of 2012, with the MSCI World Index up 2.6%. The 12-month return was an impressive 16.5%. This was led by a robust 18.6% return from the MSCI Emerging Markets Index. The old saying that ’bull markets climb a wall of worry’ was particularly appropriate for this past year since market participants worried greatly about Europe’s recession and sovereign debt crisis, China’s pronounced economic slowdown, and the fiscal cliff risk of recession posed by US politics. Such worries were offset however, by more than 300 announcements of growth-orientated monetary and fiscal easing measures over the past fourteen months, and by evidence late in the year that the US was preparing to deliver a pragmatic solution to the fiscal cliff issue.
It is hard to imagine that it is now more than four years since investment markets were transformed into a world of elevated risk awareness – following the negative forces unleashed by the bursting of the credit bubble in 2008. As has been the case in recent years, 2012 was again a year in which investors incurred many bumps and bruises as the manic-depressive mood swings continued. Bouts of good news, while causing some positive reaction, are now mostly treated with distrust and scepticism. Any setbacks are in turn viewed as confirmation of the longer-term bearish headwinds facing the developed world. We do not disagree with such a defensive and protective mindset, and have long argued that the aftermath of the credit bubble would be felt for a long period of time. History suggests that a minimum of ten years is necessary for debt levels to normalise following such a massive debt overhang. 2013 is probably only the halfway mark in dealing with the aftermath of the credit bubble.
However, the key measure of 2012 worthy of note is that, despite the mood swings, global equities managed to eke out a decent return for the year. In our opinion this is a consequence of the lack of attractive investment alternatives available to investors. In an environment of generational low interest rates it stands to reason that equities, paying dividends in excess of the long-term government interest rate, must ultimately attract buyers. This is especially true if one factors in that many high-quality multinational consumer goods companies are growing their profits and dividends at a steady rate. The 16.5% return from equities in 2012 represents a trend that we believe will continue over the next three to five years. In essence, what we mean by this is that we envisage an environment (of which 2012 is an illustrative example) that will be characterised by the following broadly recurring patterns:
- 2013 will, in all likelihood, be fraught with problems and risks – as was the case in the preceding five years. Investors will continue to fear the worst (a renewed recession) each time another setback occurs on the road to debt reduction. As a result, there will be sharp market falls from time to time.
- Governments, being terrified of slipping back into recession, will continue to be extremely accommodative. This will take the form of low interest rates, monetary infusions into the system and general back-stopping of any unforeseen threats to economic recovery that may occur.
- Governments will follow a benign tolerance of any rise (unless dramatic) in the headline inflation rates in developed economies. Interest rate rises will therefore lag any inflation increases.
- Although patchy, economic statistics from the US will steadily confirm that the economy is improving at a level that will allow companies, on average, to continue to grow profits.
- Investors, especially retail investors, will reluctantly but steadily reach the conclusion that owning shares in a debt-free company, paying a growing dividend yield of 3%, is infinitely more sensible than lending money to a debt-laden government on a yield of 1.5%.
- Equity markets will, despite periodic setbacks, continue to move gradually upwards, as the valuation of shares re-rate positively.
Given the frenzy around the issue of the fiscal cliff in the US, little discussion has centred on the positive consequences of a favourable resolution to the problem. Even if the resolution leaves many unresolved issues for serious negotiation till a later date, the financial press would do well to focus on the upside of a settlement rather than only dwelling on the downside. The fact is that the US economy is performing quite well despite the persistent uncertainty on fiscal policy. Yes, real gross domestic product has been growing at a below-par pace of about 2.25% on an annual basis for the past three years. But as was recently pointed out, excluding government spending, it has in fact been growing at about 3% to 3.5% per annum. In other words, the business sector’s performance does not gel with the so-called new normal scenario of a structural decline in the US economy’s potential growth rate. That is quite impressive, given the failure of residential investment (in new homes) to recover along with the broader economy. If the fiscal cliff can be avoided, the housing industry should contribute significantly to another year of solid growth in the private sector in 2013. The key variable is house prices, which clearly started moving higher during the course of 2012. The national median house price in the US rose 11% in the first 10 months of 2012; that is after a peak-to-trough decline of 33% from July 2006 to January 2012. If house prices continue to rise, so will consumer confidence and spending, especially for those homeowners with less negative equity (having seen their property values drop by up to a third).
The rally in share prices since March 2009 has been characterised by a series of powerful relief rallies, following severe corrections triggered by anxiety attacks regarding the endgame. The bears still point to the death of the ‘cult of equity’, with the retail investor in the US having largely abandoned equities and fleeing to bonds. They point to the fiscal issues and the perception that the US Federal Reserve’s quantitative easing programmes, which were aimed to lift share prices, may be losing their effectiveness. Additionally, they point out that company earnings have stopped growing and will not grow in 2013 if global economic activity is weighed down by recession in Europe and a slowdown in China. In essence, the bears believe that, although shares may appear cheap, they will remain so given that the outlook for long-term growth is weak. In summary, they argue that the long-term outlook is poor because debt levels are still too high and global productivity too low. We would argue that much of this opinion is already priced into investment markets. The S&P index in the US is expected to earn approximately US$103.94 per share in 2012. At the current level of the index this equates to a price/earnings ratio of 13.6 times. With the exception of 2011, this index has not traded at such a low year-end multiple since 1988.
Our opinion is that while some of the negative sentiment may be valid, the US economy has always proved remarkably resilient. The information technology revolution that started in the 1990s is likely to provide countless innovations in the field of energy, healthcare, education, robotics and many more. This, coupled with a slow recovery in Europe and faster growth from China, should provide enough growth to boost revenues and earnings of US companies by more than 5% in 2013. In conversations with analysts who have recently visited China, what struck them is the consensus within China on what needs to be done to transform the economy towards a more sustainable growth model. That is: more transparency, more productivity, and more consumption. While the ‘old model’ can still work in a large part of the country, there is not only a sense of urgency but also the means to carry out the necessary and obvious reforms in the Western part of the country.This is in itself a reason to be optimistic about China’s ability to accelerate growth over the coming years.
Regarding the eurozone, it should be remembered that a year ago it was the imminent break-up of Europe’s monetary union that dominated headlines, rather than the US fiscal cliff. Spanish, Italian and Greek official borrowing costs were soaring. Mario Draghi, the new European Central Bank (ECB) president, had ruled out acting as a lender of last resort to governments. That said, those who bet on the eurozone’s demise were in for a surprise. The eurozone is in fact alive and kicking as we move into 2013, with its 17-strong membership still intact. Thus far, many commentators have taken too simplistic a view of the eurozone crisis. They have overlooked how Europe’s 14-year-old monetary union has not just an economic, but also a deeply seated political dimension. At the same time, outsiders overlooked the extent to which Germans still regard Europe’s economic integration as part of their country’s post-World War II destiny. As 2012 unfolded, it became clear to Angela Merkel and her government that the cost of a Greek exit was simply too high. Above all, those who a year ago predicted the eurozone’s early demise, also underestimated the ECB. After becoming ECB president in November 2011, Mr Draghi answered ‘no’ when asked if he would do whatever was necessary to keep the eurozone in one piece – including acting as lender of last resort to governments. However, by July 2012 that position was no longer sustainable and Mr Draghi pledged to do ‘whatever it takes’ to preserve the monetary union’s integrity.
Looking into 2013, it will no doubt be another troubled year. Greece’s finances remain highly fragile and Spain faces many challenges. Elections in Italy and Germany could also distract politicians, while steps to strengthen the eurozone through banking and fiscal union could be blown off course. It also seems far from clear that the eurozone economies can create the growth necessary to cut soaring unemployment – and the resultant social unrest. However it is our opinion that, in one year’s time, the eurozone will still have 17 members, including Greece.
Looking at our currency outlook for 2013, it is probably only a very brave (or a very stupid) person who ventures an opinion on currencies, especially over such a short period. To the extent that we do have an opinion, it is that the US dollar will most likely be the stronger developed market currency as 2013 unfolds. This view is essentially predicated on our belief that the US economy will continue to recover in 2013, thereby outgrowing the depressed economies of Western Europe, the UK and Japan. This will probably be reflected in futures markets predicting a rise in short-term interest rates in the US as we move into the second half of 2013. At the same time, it is our belief that Japan – most likely under a new government – will redouble its efforts to inflate its economy. In doing so, a weakening yen seems inevitable. Our highest conviction position on the currency outlook is therefore that the US dollar will outperform the Japanese yen in 2013.
Looking back over the past two years, it has perplexed us that a number of the (very competent) fund managers in our fund of funds products have not added alpha. The reason for this is, however, quite apparent. Given the uncertainty and insecurity facing equity investors, it is not surprising that the best performing equities over this period have been those ‘high-quality’ companies that continue to generate revenue growth throughout an economic cycle. These are companies such as Coca-Cola, Nestlé, Unilever, Heineken and Swedish Match. These ‘steady compounders’ have been valued at incrementally higher ratings as investors have favoured predictability over economic sensitivity. Although a number of the managers in our fund of funds products fall into this style of investing, a number are more in the contrarian camp, choosing to invest in economically sensitive, but cheaply valued, businesses. It is our conviction that these shares – increasingly in the information technology sector – will prove to be the winners during the predicted increase in economic activity, led by the US economy, over the coming years.
TONY GIBSON is a founder member of Coronation and a former CIO. He was responsible for establishing Coronation’s international business in the mid-1990s, and has managed the various Coronation Global Equity Fund of Funds products since their inception. The longest standing fund is the Coronation Global Equity Alternative Strategy Fund, which was launched in 1996.
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