Overweighting emerging markets

Most international asset classes performed very well in July from European investors’ point of view. Indeed only few asset classes posted negative results, which were by the way broadly offset by the improvement in other asset classes, as was the case for investors holding a well-diversified portfolio. The negative performances came from the US and the UK bond and monetary markets and commodities, which were penalised by the Euro/Dollar exchange rate’s behaviour. By contrast, emerging markets equity indexes posted very positive performances.

The buoyant trend shown by international stock markets was inspired by US indexes, which were favoured by signs of recovery in the macroeconomic scenario and by above-estimate quarterly results in Q2 09. Therefore, assessing the outlook for the US stock market is crucial to predict the behaviour of major financial markets in the months to come. Corporate profits will represent the key variable. Following the positive surprises in Q2 09, analysts have become much more optimistic: based on Standard & Poor’s estimates, operating profits are expected to grow by 12% in 2009 and 33% in 2010. Corporate profits should therefore achieve the level seen in 2003, which is 37% lower than the 2006 historical high.

Nevertheless, the analysis of accounting profits provides some reasons to stay cautious about the extent of the above-mentioned improvement in profitability. On the one hand, the high spread between 10-year and 2-year US government bonds suggests that there is much likelihood that corporate profits will rise in coming quarters, on the other hand, the high level achieved by profit margins (accounting profits/GDP) in recent years shows that corporate profits will likely see modest growth going forward. Indeed profit margins, though decreasing from the historical highs hit in 2006, are still above the long-term historical average (7.2% vs 6%), in line with a future growth rate of around 3% per year based on a drop in profit margins and on the weighted average profit growth in the following 5 years.

Based on this simple model, corporate profits would be still lower than in 2006 in five years. Although the short-term prospects are relatively rosy for major US equity indexes due to the forecast rise in profits, European investors should overweight equity markets other than the US. Indeed, in the short term the upward trend of US indices could be accompanied by a decline in the US Dollar against the Euro, in line with the trend shown in recent months. But investors willing to bet on a continued upward trend in major international equity indices should overweight emerging markets. Indeed, over the last few months emerging markets have enjoyed much greater strength relative to western markets and could continue to do so in the months ahead. Emerging markets could benefit from the recovery of leading western economies, from the bounce in commodity prices (which would boost exports), and from a lower risk premium on international financial markets.

The trend of a declining risk premium on financial markets will also likely benefit emerging countries’ bond market.

The western bond market outlook is clouded in uncertainty. The US bond market scenario is similar to that of the Eurozone. Over the last few months the yield curve has steepened sharply, with the differential between 10-year and 3-month T-Bond exceeding 3% in the US. This phenomenon has been usually followed by a decline in long-term bond yields and an increase in short term bond yields. However, investing in long-term US government bonds could prove to be risky in the face of the low yields they carry, which could fall even sharper due to either a weakening of the US dollar or to an even slight increase in inflation expectations. As regards the European bond market, failing exchange rate risks the short end of the curve will likely benefit from the fact that the ECB is highly unlikely to raise interest rates for several months. The long end of the curve, although offering a greater risk profile, could be positively affected by contained inflation expectations going forward and by the convergence of government bonds of peripheral countries running large current account deficit following the widening of the spread in recent months. Betting on high-rated corporate bonds might be an alternative to invest in bond markets and obtain higher yields. Indeed, corporate bonds could benefit from a lower risk premium on financial markets even though the spreads have already contracted sharply in recent months.