Global equity markets have moved sideways or down so far through 2000, accompanied by an exceptional degree of volatility, especially at the sector level. Having started the year considerably overvalued relative to bond yields, the relative attraction of equities has now improved, partly as a result of the 25–75 basis point fall in bond yields across most markets and as a result of strong earnings growth.
Taking account of our forecast of some further (small) fall in bond yields as global economic activity continues to stabilise or decelerate, and a further year of good earnings growth, most equity markets are now in a position to deliver a reasonable positive return over the coming 12 months. This return will be some way ahead of cash and modestly ahead of bonds.
Having been underweight equities and overweight bonds this year so far, we are moving back to a small overweight position in equities by reducing cash. We are retaining our overweight position in bonds.
Only the US equity market continues to appear somewhat overvalued by historic standards, even after taking account of our bullish bond and earnings forecasts. However, closer examination reveals that this overvaluation is limited to the technology and (to some extent) pharmaceutical sectors. Financial, consumer and general industrial stocks appear well within conventional valuation ranges.
Even at the aggregate level, however, it is difficult to forecast more than 10% downside for the market on a 12-month view (given that both we and the consensus are forecasting market earnings growth of close to 15%), though that risk is higher on a short-term basis should US economic data signal a rise in interest rate risk through the remainder of the year.
The market is discounting a further 25bp rise in the federal funds rate, but no more than that. Boringly consensus though it may be, we are taking an underweight position in US equities. Bear in mind, though, that we would be taking a different view if we were expecting a major collapse in the US, as opposed to further sideways drift. A US-led collapse never leaves the US equity market worst off; the far less liquid markets of Europe and Asia always manage to fall further under such conditions. The bizarre sounding conclusion is that if you are very bearish of the US, underweight other equity markets first!
Pessimism on the state of the Japanese market and economy grew dramatically through July, taking the market back to the bottom end of its eight-year (yes – eight!) trading range. While the market still appears expensive on a trailing p/e basis, it should be able to trade back up (our forecast is for a 15% return from current depressed levels) as the economy continues to deliver choppily stronger growth which, together with corporate restructuring (however modest), generates further recovery in very depressed profit margins. Japan should be overweighted at current levels.
Continental Europe and the UK appear equally attractive on a valuation basis, with 12-month upside each of around 10%, though the same caveat applies to them as to the US: current p/e multiples are high relative to current bond yields. On a currency- adjusted basis the recent sharp pullback in the euro makes continental Europe somewhat more attractive than the UK, given our forecast that the euro can make it back to parity with the US dollar over the coming six months.
Asian equity markets, despite this year’s lacklustre performance, continue to appear expensive, in part because of higher than historic exposure to technology. Indeed, the most important asset allocation decision to be taken for the foreseeable future remains the extent of exposure to technology/media/telecom shares. While these sectors have corrected (and recovered and corrected again and recovered again) it appears very difficult to justify an overweight position under circumstances of global economic deceleration, even if the landing is (as we expect) ultimately soft. Too little regard has been paid to this sector’s traditional growth cyclical characteristics, and the valuation of these sectors leave no room for even the most modest downward revision to expectations not to end in disaster (witness Nokia).
Chris Carter is a global strategist with Investec Asset Management, London