The stock market outlook remains rosy despite last week’s widespread uncertainty, with the major indexes suffering from mild profit-taking and the publication of some negative data on the U.S. economy. Mounting expectations that the ongoing economic recovery will gather further pace in the first half of 2010 are the main reason behind the persistent uptrend in stock indices. Notwithstanding a high degree of scepticism towards the duration of the economic recovery - some economists indicated that it only depends on the fiscal and monetary stimulus implemented by the governments, emphasizing the risk of a relapse into recession in the coming quarters -, the leading international institutions are revising up their estimates for 2010 and 2011. Last week, the OECD upgraded its 2010 growth forecasts for the biggest international economies (the 30 member countries are now seen gaining 1.9% vs. +0.7% last June) and for the first time released its growth projections for 2011, which foresee a continuation of the global recovery (+2.5%).
The equity market upswing also reflects the acknowledgement that major central banks will continue to pursue an expansionary monetary policy going forward. The Fed, ECB and BoE are not seen raising rates in the first half of 2010 and might even leave them unchanged until late next year. As the Bank of England Governor Mervin King suggested speaking about UK economy during the presentation of the latest “Inflation Report”, a short-lived return of the UK GDP to its pre-crisis level would not be enough to make up for what the country has lost over the last two years.
Expectations that major central banks will not tighten rates for a long time are impacting the Government yield curve: the differential between the 10-year and 3-month government Bond yields is over 300 basis points in the U.S. and UK and more than 280 basis points in the euro area.
The graph below shows that a very steep yield curve has been traditionally followed by a very positive performance during the following 12 months in the S&P 500, the leading indicator for the overall U.S. stock market.
As we suggested in the post S&P500: a mildly positive outlook, the S&P 500, with an average P/E ratio for the past 10 years of 19 (broadly in line with the post-WW2 average), does not look overvalued, despite the strong rally staged in recent months. Given the positive outlook for the S&P 500, with a consequent positive impact on the whole of international indices, we recommend overweighting other equity indices. Indeed, the weak dollar is a great concern for the U.S. stock market. Over the last few months, there has been a strong reverse correlation between the US Dollar and the S&P 500. The equity market rebound has combined with a fall in the greenback and vice versa. Therefore, a new rise in equity markets might prompt a further drop in the U.S. currency, even though many indicators (including the OECD’s Purchasing Power Parity) have suggested that the US Dollar is more than 20% undervalued against the Euro. By contrast, emerging markets, which are benefiting from a reduction in the size of the financial risk premium, should be favoured more than the developed countries by the international recovery, even due to currency appreciation. Although the risk/return profile of emerging markets has worsened in the wake of the sharp rise since last March, we recommend betting on a continuation of the emerging markets uptrend.