Recent economic data have been rather lacklustre, yet many equity markets – including those in the US and Germany – have recently reached all-time highs. This apparent dislocation is not as crazy as it might seem.
First, much of the recent weakness in economic activity is likely to be temporary, and the prospects for a recovery late this year look good. Even in the eurozone, economic conditions should get less bad in the second half of this year and into next year, led by a recovery in Germany, and while Europe may not contribute much to the global economic recovery, it should benefit from one.
Second, global inflation remains controlled and is likely to fall in some countries. True, concerns about a slowdown in quantitative easing have surfaced recently, but the resulting rise in yields has largely been in real yields, as inflation expectations have remained under control. This is a benign form of higher bond yields that can coexist with strong equity markets.
Third, lower inflationary pressures continue to provide the cover needed for ongoing supportive monetary policy; this is both easing global financial conditions and supporting real asset prices.
Fourth, while equity prices have rebounded strongly since the crisis, valuations in aggregate look reasonable, particularly given low interest rates and the gap between implied risk premia in equities and other asset classes (which in many cases have fallen to record lows).
Fifth, equity market levels relative to previous highs are not all that meaningful. The FTSE 100, for example, is close to all time highs, but is still 6 per cent below the level it reached at the end of 1999. In inflation-adjusted terms, it is still 31 per cent below its peak 14 years ago.
The gradual rise in risky assets is likely to continue as risk premia moderate further, and as profits and dividends grow on the back of an improving global economic cycle. So what should investors buy?
So far this year, many of the leaders in equity markets have been the least economically sensitive companies. Much of this can be explained by the combination of scarcity and uncertainty. There are two sought-after features of investments that are currently scarce: income and growth.
Income is difficult to find in a yield-starved world, and one that does not look like it is changing any time soon – think of the return available in your personal savings account.
In the US, the best dividend yielding stocks have outperformed the broader market for many months as bond yields have fallen. Investors searching for yield are gradually being pushed up the risk curve.
In Europe, the picture is more complicated, given the prevalence of structurally challenged companies seen as “yield traps” – because they appear to offer high income that then evaporates when they are forced to cut or eliminate dividends. Nevertheless, the strategy of finding higher yielding companies that can increase dividends has worked well, and should continue to do so.
The search for growth, meanwhile, has also been more nuanced. So far, the only type of growth investors have paid a premium for is highly visible sales growth as opposed to earnings growth. Hence the strong performance and premium valuations of many of the defensive sectors, such as consumer staples.
Companies with stronger earnings growth have generally performed well but not attracted a valuation premium. This makes sense in an uncertain world where investment horizons shrink; investors pay for what they can see rather than what they hope might happen.
But as risk premia moderate and future growth prospects improve, the premium being paid today for stable and visible top-line growth looks too high in many cases. Preferences may shift towards more cyclical companies that can grow earnings by improving margins from cyclical lows.
At the same time, we should see a rotation in geographical returns. Europe and Asia may have more room to catch up with the US in terms of returns as margins recover from cyclical lows, despite their worse economic outlooks.
In Europe, the outperformance of the Swiss market – well endowed with stable top-line growth companies – has been understandable when risk premia were rising sharply, but its continued outperformance despite a moderation of risk premia over the past nine months looks stretched.
We recommend reducing exposure to the Swiss market and raising weightings to the FTSE 100 as the UK finally recovers and many companies also benefit from improved growth elsewhere.
Peter Oppenheimer is chief global equity strategist at Goldman Sachs
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