The second quarter just ended was a bumpy quarter which saw world equity markets fall by 1.5% in euro terms, while government bond markets made modest positive returns (1.6% as measured by the ML benchmark 5 year+ index).
As we progressed through the quarter the headlines were dominated by Greece and concerns about the sustainability of the US and global economic recovery. In particular through April and May economic data releases confirmed some “loss of momentum” in the pace of recovery, with much of this attributed to the after effects of the Japanese earthquake and the impact of high commodity prices on consumer spending. Commodity prices fell from their first quarter highs during the quarter, as oil fell 11% and corn was down 9% for example. Despite the macro headlines and market volatility there was very little movement in major currency exchange rates: the Swiss Franc was a notable winner (up 6% versus the euro on the quarter), reflecting its safe haven status!
To place the quarter into a more meaningful perspective, the US recession officially ended two years ago in June of 2009 and during those two years we have had 8 continuous quarters of positive but anaemic and bumpy growth. Growth has been volatile from quarter to quarter just as it has been in Q1 and Q2 of this year. During those two years world equities have roughly doubled, with global central banks focused on making sure that positive growth remains in place despite the ongoing slow deleveraging process and other structural headwinds. Emerging economies, however, are in much better shape and continue to grow strongly, leaving total global growth close to normal pace.
Market sentiment at present is certainly concerned about a relapse back into recession. Our view remains that the global economy will continue to grow at a sub-par moderate pace over our 12-18 months investment horizon, and this remains a supportive background for asset markets. In our view there is no silver bullet solution to the macro challenges: these solutions will be worked over the years ahead and money will be made in risk assets such as equities, but investors need to be patient in what will be a volatile but positive slow grind upwards.
You have read a lot about “bond spreads” in the press and media over recent months but I want to alert you to “spreads” you don’t hear as much about, namely that over recent months there has been a growing divergence between bond yield and equity valuations. In a historic context it is not unusual to see such periodic divergences, but they don’t last for long. I highlight it because to me they summarise where market sentiment is currently priced in markets: bond prices are unusually high relative to equity prices, which is a classic signal that markets expect growth to be very low, even at recession levels, in the months ahead. Since, in contrast, we believe that growth will remain around at current levels, there is a good case to prefer equities relative to bonds.
My clear perspective is that as an investor you will be rewarded by favouring equities over bonds. The reward will arise as sentiment swings back.
The Greek impasse will move on
I believe that market sentiment and bond prices versus equity prices are currently priced to reflect fear of a “Summer Crash” caused by a sovereign default from Greece. The most probable outcome however is a more middle of the road combination of further austerity measures in Greece, a second bailout payment in return from the external authorities and probably some voluntary “re-profiling” of debt. While such an outcome isn’t a silver bullet and restructuring of Greece will continue for years, it should be sufficient to take Greece from dominating the headlines, result in some upward re-pricing of risk assets such as equity markets and allow markets to focus on matters other than Greece.
The challenge to this scenario is that Greece doesn’t emerge with such an outcome and moves more quickly towards sovereign default. While unlikely, it’s a scenario to actively monitor and one that we would respond quickly to.
The world beyond Greece matters most
I have outlined the anaemic but positive economic growth environment we expect and that we do not expect a relapse into a global recession. We remain alert to the risks but also focus on the many positives that should ensure some strengthening of growth over coming quarters. For example, while western governments and western consumers are generally heavily indebted, remember that their counterparts in emerging economies are not, and they remain a strong engine for global growth.
Equity markets may well switch their focus from macro to micro matters. Over coming quarters, I believe real leadership will emerge from the corporate sector. After a couple of years of positive economic growth and strong balance sheet focus, corporate balance sheets and profits are in excellent shape. We expect that corporate profits will continue to grow year on year albeit not at the pace of the last couple of years. As time passes and profits grow further, balance sheets (with the exception of the banking sector) are increasingly awash with cash. I expect that in a sluggish macro environment for top line sales growth, but one where some price inflation will help, management teams will increasingly deploy their cash.
The investment of cash will be via capital expenditure and some hiring, but primarily I expect will be focused on M&A, share buybacks and increased dividends. Given the nature of this slow economic recovery, I expect that companies with financial strength will be the winners and the ones best placed to deploy their balance sheet and to accelerate their growth and/or total shareholder return, via higher dividends payments for example.
Looking to year end: further potential for gains
I characterise markets as currently in a “glass half empty” or “risk off“ mode and understandably so as they respond to the various macro concerns that abound. For multi asset portfolios we have been relatively neutrally positioned through the second quarter. Looking ahead to year end and beyond, I believe it appropriate to adopt a more constructive “glass half full” mindset as I do believe markets will end the year higher than at the half way stage.
Such gains will primarily be driven by positive fundamentals and particularly by continued profit growth by companies and their ability to create their own headlines via M&A and buybacks etc as outlined above. I am also mindful that sentiment is currently very poor and markets priced accordingly. As with sentiment it is also clear from surveys that investors such as hedge funds are sitting on the sidelines somewhat and are not as leveraged to equities as previous times. Such sentiment and technical positions are noteworthy and potentially bullish also.
At KBI Global Investors we remain focused not just on the well documented challenges that face investors in the current uncertain world, but also on the opportunities they present from a client portfolio perspective. Our central thesis remains constructive to risk assets and if anything possibly increasingly so right now, but not without having our eyes open to the downside risks. At a macro level there is much focus and reliance on Governments and Central banks to continue to do the “right thing”: from our perspective a key focus is on the outlook for corporate sector.
We remain focused on meeting companies globally, challenging their business models and discussing their trading environment and particularly their profit outlook. We expect profits to continue to grow and to drive share prices higher, hence the strong focus on same. The other strong focus is on plans for deploying strong cash balances from here.
In line with our central scenario, we believe themes such as corporate balance sheet strength, strong cash flows, attractively growing dividend yields and positive earnings momentum will be the winners. Such companies are best positioned to win on the upside and also are best placed to offer protection on the downside we believe.