The current market circumstances give rise to some frustration for market commentators and participants alike. It is one of those periods during which it has become abundantly clear that the development of equity prices and interest rates is not one related to a certain set of factors but rather reflects a multitude of influences varying in their timing and impact. Despite an increasing amount of information and high levels of sophistication in measurements and calculations, the search for the characteristics of the succeeding cycles remains a major challenge.
The economic development is often described as ‘equity positive’ because the recovery which has become increasingly apparent will impact the earnings positively, especially due to the cost-cutting efforts in the recent past. At the same time, this turn-around is considered to signal an increase in interest rates. Comparing this positioning with the actual development, one notices a less pronounced interest rates increase and a negative return on the equity markets in general.
There are many factors given to ‘explain the non-explained’, but sentiment seems to figure as favourite. Sentiment and reasoning is battered down by uncertainty with regards to the earnings development not the least as a consequence of increasing evidence of earnings manipulation by management of companies. Other factors often mentioned to explain the ‘feel-bad’ sentiment are political turmoil and the fear of terrorism.
Apart of having a sentimental twist, the current cycle looks as though it is heavily influenced by excesses developed during the last upward cycle. These excesses were to do with investments in information technology as a tool to increase productivity and stimulate competition. Driven by the exceptional earnings, typical at the start of a new development, investors were quite willing to participate in the ‘new economy’.
However, the bursting of the dot.com bubble is proof again that extrapolating growth rates at the beginning of a rejuvenating technical development over a longer period is an extremely tricky exercise. By doing so, money for investments in this field became abundantly available and the discipline that normally is exercised in calculating and analysing returns on financing capital expenditures was less rigorously applied.
Next to the technical renovation and the high initial returns of their application, the third horse of a troika that pulled the returns on investment to unprecedented levels was the accommodating monetary environment made possible by the low-inflation environment that resulted from the inflation restraining global competition and by the application of information technology.
If indeed the current situation reflects a correction of a development that gained too much momentum, one may assume than we are in the process of rebalancing. The development that caused the imbalance and consequently the confusion about earnings growth and valuations of equities as such is beneficial, namely a more effective way of allocating production resources and distributing products and services. The adoption of this ‘new economy’ in the existent production structure of the ‘old economy’, integrating the two, is the balancing act which raises confusion.
At the same time, the monetary background had become extremely investor friendly where the authorities have to guard for excesses and balancing the developments gain priority.
What are the investment policy consequences of an environment that has been spoiled by all the goodies of exciting new techniques, uncommon high returns and easy money and is now suffering the after effects? The most likely scenario seems to be that economic growth will become more apparent and earnings will resume an upward movement. It is not expected, however, that the gains to be made will be of the same magnitude as during the preceding upward cycle because investments will be more subdued as investments in information technology will not be as exuberant. Such a development will limit earnings multiple expansion. Valuation will also not be stimulated by interest rate decline because monetary authorities do not have the room to manoeuvre the interest rates significantly lower. A gradual tightening looks more probable if the economic growth accelerates in order to keep inflation under control. As a last point, one must take into account that earnings reporting will be more conservative after a period during which earnings tended to be calculated to the upside.
Our investment stance therefore is to favour equities over fixed interest however in a modest way. On a sector base the longer-term cyclical sectors look to have the best upward price potential. On a regional base, emerging markets look to merit overweight because they can profit from a global recovery and the valuation looks attractive. On the other hand, Japan is still facing structural problems while the cyclical recovery looks to be discounted in the current valuation, an underweight looks to be the preferred position.
Martijn Hes is asset allocation strategist at ING Investment Management in the Netherlands