Historically, there has been a rather close relationship between the relative performance of US equities against bonds and the year on year change of the OECD leading indicator. This should not come as a surprise because, after all, the behaviour of investors is, to some extent, a function of their expectations about future economic developments: an improvement in the economic outlook will trigger upward revisions in earnings and increase the willingness to buy equities.
At the same time, bonds become less attractive because of increased inflation fears. This is the textbook case. What is clear however, from the accompanying graph, is that the past couple of months did not exactly fit this textbook case. The explanations are varied: a short-lived rebound of economic growth in the first quarter, accounting scandals, earnings disappointments, deflation fears, rising political tensions (Iraq), etc. As a corollary to this, US bond yields have reached almost ‘abnormally’ low levels whereas our calculations show an implied nominal growth rate of earnings of European companies for the coming five years of barely 1.7%. Normally, one would expect a figure close to the potential nominal GDP growth, eg, 4-4.5%.
Where do we go from here? On the economic front we think that the recent weakness of industrial production growth in the US is a logical consequence of the completion of the inventory correction in the first half, and should not be seen as the beginning of the second leg of a ‘double dip’. As such, we maintain our view of weak but still nonetheless growth in the second half of the year. Near term, we expect the demand indicators to moderate a bit in the fourth quarter after growing strongly in the third (the wild card would be the strong cash-out effect from mortgage refinancings which could boost Christmas sales, which is a distinct possibility). At the same time, we see business cutbacks fading, leading to a better labour market and improved production numbers. As always, the ISM index will be a key indicator.
What are the risks to this scenario? Renewed equity market declines, a further deterioration in the labour market, additional cutbacks in investment spending (though the year on year growth of durable goods orders has improved steadily this year), a collapse in the housing market (not very likely), the re-appearance of a credit crunch. For the rest, recent data on the Eurozone suggest that this area could be the weakest link in the global recovery story. Euro-zone business sentiment continues to be hurt by uncertainties about the impact of the fall in stock markets and the cooling off of global trade growth over the summer (net trade was the main contributor to GDP growth in the first half of the year). Moreover, the Euro-zone suffers from weak domestic demand (especially in Germany), at a time where the policy mix is under pressure from the deterioration in the budget deficit. Overall, we see the Euro-zone economy as more balanced than the US (which is characterised by, amongst other things, high levels of indebtedness, a low savings rate and a structural current account deficit), yet offering growth prospects which are lower in comparison with the US. Finally, on the Japanese side, the rebound in foreign demand has not led to a self-sustained recovery of domestic demand. We maintain our view that this economy will continue to grow in the coming quarters but at a rate below the potential growth rate, which is already lower than in the other major economic regions. The wild card to this global view remains a geo-political shock impacting domestic demand (in the US to start with) and global trade.
In our asset allocation we recently closed our slight underweight in equities. The main argument here is that we believe that the current sentiment is too negative and therefore the market looks oversold. Market indicators (VIX, bull/bear recommendations, insider buying, etc) underpin this assessment. Moreover, valuations based on bond yield/earnings yield using published earnings are significantly below the average since 1973 in Europe. The same is true for the US, albeit to a lesser extent. Finally, third quarter earnings should (again) exceed expectations, after the pre-announcement season had brought them down.
We feel that it is too early to go overweight already. Although profit guidance ratios for both the third and fourth quarters improved recently – they have become less bad – we are afraid that fourth quarter guidance will have to come down. Also, for the rally to last, we need a batch of economic data that dispel fears of a relapse into recession. Finally, geo-political tensions will not disappear rapidly.
William De Vijlder is managing director and chief investment officer at Fortis Investment Management in Brussels