Equity market outlook remains positive

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.

Gold, the only means of effective portfolio diversification

In the commodity world a special place must be reserved for gold because of its peculiarities, which make it a must-own asset for many investors.

As mentioned in the post How many risks behind commodities, gold is one of the few raw materials with a very low correlation with the stock market - a correlation that has not increased sharply over the past two years. Therefore gold is the only asset that seems to still be able to provide the necessary diversification within a portfolio. The peculiarity of gold has also been underlined by two IMF economists, Roache and Rossi, in a study published in July 2009 ("The effects of economic news on commodity prices: Gold is just another commodity?"). The two economists have discovered that gold is the only commodity to respond to major macroeconomic data published in the U.S. and Euro area and that such movements are counter-cyclical, in line with its status as a safe haven. Gold should also defend the portfolios both in case of a surge in inflation, as it happened in the '70s, and of deflation, as it happened in the '30s. However, the ability of gold as having a positive impact on the portfolios of European investors could be severely limited by the performance of the Euro/US Dollar. The recent rise in the bullion, in fact, has been accompanied by an increase in the single European currency. Although gold has hit a record high above $1,000 an ounce, for European investors this is still almost 9% below the record high set in March. Buying gold could be a rewarding choice in the long run should the crisis of the last two years not be fully overcome or inflationary pressures increase but in the near term, investing in gold might turn out to be disappointing for European investors.

What is behind gold rise above US$1000oz ?

Last week, market attention focused on the increase in gold prices, which marked the US$1000oz threshold for the first time since last March. Various explanations were provided for the upward trend in gold prices. First, fear that the ultra-expansionary monetary and fiscal policies adopted by central banks and governments around the world, particularly in the U.S., might prompt a sharp turn to the upside in inflation over the coming quarters. Indeed, over the last few decades gold has turned out to be one of the most reliable indicators for estimating the inflation trend in the subsequent 12 months. For this reason, the rise of gold prices to a new high would send a warning signal on the inflation outlook for the months ahead, and the consequences would be felt primarily on long-term interest rates. Nevertheless, inflation concerns appear to be overdone as the inflation outlook for the coming months does not look particularly alarming, given the low capacity utilization and the continuation of the deleveraging process by leading international economies. The expected inflation rate, calculated as the difference between the 10-year nominal rate and the real rate on Treasury TIPS, has now steadied around acceptable levels and is in line with the historical average.

Paradoxically, the rise in gold prices could be evidence that the market should begin to price in a deflationary scenario. One of the main lessons of the Great Depression in 1929, in fact, is that gold may be a hedge against the currency devaluation imposed by the monetary authorities during the most severe deflationary phases. Despite signs of an economic recovery in recent months, worries that the economy might get into a prolonged deflationary cycle have become increasingly acute. Indeed core inflation could continue to fall for several months even under the most optimistic hypothesis that the US pulls itself out of recession. The slowdown of core inflation might even deepen should the W-shaped economic scenario much-feared by some economists materialize.

Therefore, the reasons for higher gold prices should be found elsewhere. One possible explanation may offered by the purchases of gold made by the Chinese government. In an interview with the UK daily newspaper at the Ambrosetti Workshop in Cernobbio, a Chinese government official said that the country’s authorities are concerned about the repercussions of the ultra-expansionary U.S. policy on the US Dollar and pointed out that gold is a viable alternative to the greenback, although market purchases must be made with caution not to push higher gold prices. His words appeared to confirm that China aims to increase the proportion of gold in its reserves, hence persuading traders that gold prices are likely to go up in the medium term.

Investors’ behavior might offer another reason for the rise in gold prices. Following the investment boom in 2007, commodity investments were stopped in 2008 but recovered in the first half of 2009 (as highlighted in a recent report by Macquarie) thus favouring a rebound in commodity prices from the depressed levels last seen at the start of this year.

Finally, gold prices might have been driven higher by the belief of major gold producers that the upward trend in gold prices is set to continue into the coming months. During the week, in fact, Barrick Gold, the world’s No.1 gold producer, unexpectedly announced its plan to spend $5.6 billion in the third quarter to close out its hedge book. The closing out of Barrick’s hedge book is likely to bring further pressure on prices and forcing competitors to implement the same move.

Whatever the real reason behind the gold prices increase, most investors believe that gold prices are highly likely to mark and leave definitively behind the US$1000oz threshold. A recent survey conducted by Bloomberg showed that 10 analysts out of 12 believe that gold can exceed the record high of US$1033oz hit in March 2008 in the short term. Some analysts also believe that gold prices will likely continue to follow their upward trend in the months to come. As an example, Citigroup’s technical analysts in a report published in late August have estimated that gold may go up to US$1190oz and reach US$1300oz by the end of this year.

Institutional investors looking for a further increase in gold prices include CMC Markets, with a year-end target price of US$1200oz, and Investec Asset Management, which sees gold rising to US$1150oz. By contrast, Heraeus Precious Management sees gold prices nearing US$1050oz in the short term but retreating to US$700oz by year-end.

Anticipating the trend of gold prices is no easy task. Therefore, holding the precious metal seems to be an advisable option at this time of year because of the high uncertainty surrounding the economy and with a view to protecting the portfolio risk exposure. 

September calls for a prudent asset allocation

Major international stock indices rose in August as the downward trend in the market risk premium, which began in March, continued. The expected upturn in economic activity in the months to come is the main reason for the positive equity market momentum. These expectations were reinforced in mid-August by Fed Chairman Bernanke’s statement during the Federal Reserve Bank of Kansas City's Annual Economic Symposium in Jackson Hole. Indeed, the Fed chairman, who was confirmed for a second four-year term by President Obama, said “Economic activity appears to be levelling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good”.

The last few weeks have brought a spate of forecast-beating economic data, which have strengthened expectations of an upswing in leading international economies. In the U.S., optimism has been fuelled by encouraging data from the housing sector. Reassuring signals have also come from improving consumer and business confidence indices (the ISM manufacturing exceeded the 50 threshold, which anticipates a return to growth in the manufacturing sector).

In the Euro area broadly positive news came from France and Germany. Surprisingly, both countries saw positive GDP growth rates in Q2, as clear evidence that the recession may have already ended for the two largest economies in the region. These figures also gave grounds for optimism over the whole of the Euro area economy, albeit the overall Q2 GDP figure remained in negative territory.
The possibility that the economic outlook will continue to improve in the coming months thanks to the strong monetary and fiscal stimulus implemented by the Governments and Central Banks in recent months should help lift major stock indices going forward.

A return to economic growth would bring investors to discount a sharper increase in corporate earnings in the coming quarters. A positive signal for the stock market is also the high spread between the 3-month T-Bill and the 10-year T-Bond, which has historically been followed by marked increases in U.S. indices.

For these reasons some investors are looking for sharp increases in equity markets over the coming months. According to Laszlo Birinyi of Birinyi Associates, the S&P500 may rise up to 1700 points during the next two to three years.

Nevertheless, we see many reasons to stay cautious on international indices in the short term, particularly due to seasonal factors. Indeed, September is a historically negative month for the U.S. and major international stock markets.

Moreover, following the rally staged since last March, major international stock indices do not appear to be cheap any longer. For example, the price/ average earnings for the past 10 years ratio, after plunging to 13.3x in March, its lowest since 1986, has now risen to 17x, a level in line with its long-term average.

Therefore, we recommend selecting a prudent short-term equity market asset allocation in September. This is particularly true for emerging markets indices, as shown by the steep decline in the Chinese stock market in August (the Shanghai Stock Exchange lost around 15%).

Moreover, market expectations for economic growth going forward may prove to be overly optimistic. On the one hand, some Central Banks have begun to entertain the possibility of raising rates (the Central Bank of Israel was the first CB to lift rates on 24 August, from 0.50% to 0.75%), on the other hand the Fed and ECB seem eager to wait much longer to reverse the current expansionary monetary policy as they believe that the incipient economic recovery is still fragile. Among major international central banks, the Bank of England pursued an even more aggressive expansionary policy in August by increasing its Asset Repurchase Programme. The BoE Governor, Mervyn King, suggested that a return to economic growth in line with the average of the past would not be enough to regain the ground lost in the past two years.

With major international Central Banks unlikely to reverse their expansionary monetary policy any time soon, short-term Government Bonds in both the U.S. and Euro area should continue to be a safe haven for risk-averse investors, as the chances of a steep rise in yields look slim, at least in the near future. In particular, European investors should continue to invest in European securities given the uncertainties surrounding the U.S. dollar. Risks seem to be contained even for long-term Government Bonds as fears of a strong increase in inflation as a result of the expansionary monetary policies implemented in recent years should not materialise in the months ahead.

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.