The old adage ‘sell in May and go away’ did not apply this summer. Indeed, shares outperformed bonds (8.5% outperformance worldwide) during the third quarter. Most stock market indices made solid progress on both sides of the Atlantic ocean (up 6.3% in Europe and 4% in the US), essentially on the back of a renewed interest in cyclical and technological stocks.
During this rebound, investors especially focused on the improvement of the momentum that was driven by better macroeconomic news. Indeed, the global fundamental context improved during the past two quarters. Fears of deflation gradually abated, as geopolitical uncertainties receded. Bond yields climbed significantly from their all-time lows of June (up 3.1% in the US, 3.5% in Europe). In the meantime, the first tangible signs of a recovery started to emerge, particularly in the US. US activity growth gained momentum, business sentiment improved (the ISM index is now above 50) and corporate balance sheets started to improve. Even though companies have so far strengthened their profit margins through lower costs and lower interest charges, sales will, in our opinion, also boost corporate earnings growth on the back of the better world economic environment.
This increase in earnings had, of course, an impact on the general sentiment. Indeed, good US corporate results in the second quarter (up 10% quarter on quarter) reassured the market and were even much better than analysts forecasts (positive surprise of 5%). Consequently, we believe that analysts will no longer scale down their earnings forecasts in the US. After the drastic revisions early this year, analysts expectations are now more in line with reality and are, from now on, confirmed our own estimates (12% expected growth in the United States). In Europe, on the other hand, earnings forecasts have not increased yet, but they have stabilised since June.
We are, however, aware that the recovery of world activity is still fragile. The sustainability of the economic recovery closely depends on the future developments on the labour market that will drive the consumption momentum. In the US, households still have to face difficulties in the labour market. The pace of job growth is currently much slower than at the end of previous recessions. In Euroland, the corporate cost control measures are also hurting local employment. Yet this negative impact could be offset by a rebound in domestic consumption in Euroland in the medium run. The level of indebtedness of Europeans is indeed much lower than that of American households and, hence, their spending potential is substantial.
The Japanese Stock Exchange has been buoyed up by a favourable momentum for months. Local business conditions have, indeed, significantly improved. Unemployment has decreased and economic agents have gradually become more optimistic after years of deflation. The continuation of the recovery and a movement in the portfolios of foreign institutional investors who are still very underweighted in Japanese stocks might continue to support the market in 2004.
Given the more favourable economic and financial conditions, we have been showing a slight preference for shares in the mixed portfolios for several months now. The recently renewed concerns – translated into a stronger risk aversion in September – did not induce to change positions given the modest overweighting. Despite the growing doubts of some investors about the world recovery, we think that stock markets still have upward potential. Therefore, the calculation of a risk premium can teach us many things. The current risk premium for the S&P500 index is 2.5%, which is much higher than its 10-year average (1.5%). Of course, this premium shrank during the summer rally but, in the assumption of a return to the average, another drop of 1% of this risk premium would imply an increase of about 10% in equity prices, other things being equal.
As far as country allocation is concerned, we are particularly bullish about emerging countries – especially Asian countries – as well as Japan. Both zones will take advantage of the world recovery. Moreover, the general decrease in risk aversion will lead to strong corporate earnings growth in the region. Besides, Asian emerging countries will be helped by the good economic conditions in China. In our sector portfolios, we give preference to a slightly pro-cyclical positioning with selective overweights in cyclicals and selective underweights in defensive sectors. We consider current valuations reasonable, certainly in the light of low interest rates. All in all, we are optimistic about global equities over the next twelve months.
As far as bonds are concerned, we believe that the gradual improvement of corporate results will continue to boost high yield bonds. Despite the good performance of junk bonds in the past few months, we think that they still are attractive and, hence, that they still have upward potential. They will probably continue to outperform government bonds within the next few months. The outlook for both emerging market debt hard currency and local currency remains favourable.
Guillaume Duchesne is a member of the global asset allocation team at ING Investment Management in the Hague