Outlook For Corporates 2013

By M. Isi Eromosele

2013 will be an interesting test of nerve for corporates, both the executives that run them and the institutions that invest in them.

The financial markets and developed economies are clearly in a fragile state with numerous situations, particularly the Eurozone crisis, capable of delivering sharp shocks to market confidence.

If the Eurozone situation deteriorates, there could be severe disruptions to multiple areas of the global market with capital becoming harder to raise, counterparty credit risk increasing, commodity prices falling and large parts of the developed world slipping into recession.

But if the situation stabilizes or improves, there could be very favorable conditions indeed for corporates with growth returning to the U.S., Europe shrugging off recession, share prices rising, falling credit spreading and the return of liquidity to the capital markets.

The vast gulf between these two scenarios makes the strategic choices taken by corporates in 2013 especially important. The two key questions for corporates, as always, are how to employ capital (if they have it) and how to raise it (if they don’t).

The choice in the former is between growth (expanding capacity and/or making an acquisition) and consolidation or defensive strategies (buying back shares and initiating or increasing dividends).

Buying back shares certainly appears attractive whatever the economic conditions. U.S. equities are currently trading at their lowest multiples since March 2009 and are now, in the opinion of our equity strategists, 30 percent below fair value.

Dividend increases seem more suited to negative economic scenarios. In a rising market, they will not significantly enhance share prices. In a weak or falling market, with investors focusing on income rather than capital growth, it could have significant benefits.

The choice between organic capacity expansion and mergers & acquisitions is, perhaps, the most intriguing. In some sectors, growing earnings significantly through organic growth alone may be challenging.

The pharmaceuticals industry, for example, appears to have hit a ceiling in the area of new drug development with slow progress on new drug approvals making it hard to maintain returns on research and development above the cost of capital. Here, the focus is likely to be on mergers & acquisitions.

Prospects for M&A activity generally look strong. According to Deutsche Bank’s 'M&A affordability index' which looks at debt financing costs, growth expectations and other variables, the conditions for M&A are now the strongest in recent history

In others, the case for capacity expansion is compelling. Investment in cloud computing technologies and services, for example, looks set to increase by 19 percent in 2013 with large technology vendors like IBM expected to spend over $50 billion on new infrastructure in the next three years.

Emerging markets continue to offer significant opportunities with Africa emerging as a region with particular potential.

Expect to see large cap companies continuing to spin off non-core assets and using the proceeds to increase their operations in Asia.

In financing, the outlook for 2013 is broadly positive. Demand for non-financial investment grade corporate bonds is strong (partly because of investor concern about the banking sector), and interest in high yield paper has picked up significantly in recent months.

This suggests that many companies will be able to raise large amounts of debt in the public bond markets in 2013 at extremely competitive rates of interest.

The outlook for equity issuance is also positive, providing there is some stabilization in the macro-economic and market climate.

However, it seems likely that there will be some periods of instability in both equities and bonds when (because of macro events) the markets close to certain issuers, just as they did in 2012.

Given this, it would seem prudent for corporates to raise as much as they can, as early as they can in the year to protect themselves against prolonged market closures.

An interesting alternative to public equity issuance are private funds such as sovereign wealth funds and private equity funds, many of which are actively looking to take strategic stakes in selected corporates.

Another key area that corporates will need to focus on is risk management. During 2012, there were some very severe, sudden swings in both commodity prices and exchange rates. This increased the cost of hedging using plain vanilla products and made multi-asset hedges more attractive. Expect this to continue in 2013.

Corporates will also need to address multiple issues in pension liabilities. Estimates for the funding gap for U.S. corporates range from $400 to $500 billion depending on discount rate assumptions. Studies indicate that for each 1 percent decline in rates, these liabilities will increase by between 10 percent  to 15 percent.

Corporates that are able to understand and monitor these risks and have the systems, staff and infrastructure to identify appropriate hedges will outperform.

The uncertain regulatory outlook for hedging products such as interest rate swaps and FX options is a further complication where there will be greater clarity later in the year.

All in all, 2013 will be a challenging but potentially very exciting year ahead.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2013 Oseme Group

Outlook For Global Equities 2013

By M. Isi Eromosele

U.S. Equities

Despite ongoing skepticism, the outlook for earnings looks good and expect them to grow by 7 percent in 2013. S&P 500 earnings per share (EPS) recovered to near trend levels in Q2 2012, and then grew robustly in Q3, making them the one clear element that has exhibited a classic V-shape in this economic recovery.

With a baseline of slow GDP growth , sales will continue to grow significantly faster in 2013, as is typical in economic recoveries, with margins remaining well supported.

True, the multiple remains within its historical one standard deviation band of 10 to 20 but it is 30 percent below fair value in our estimation. So will the multiple continue to de-rate in 2013 and fall to the bottom or below these bands? Or will it rise toward fair value?

There are a host of reasons why the multiple will remain low. These include the lack of investor demand for equities when 10-year returns are near zero; an ageing population which is raising the relative demand for fixed income; the unsustainability of earnings made by cost cutting and cyclically high margins; a higher uncertainty premium with potentially more frequent business cycles; macro policy uncertainty and sovereign debt risks.

However, there are reasons to be optimistic on prospects on for the multiple in 2013. These include:

• A U.S. recession is unlikely. Recessions typically happen late in economic cycles when companies are over-extended and cost pressures rampant. With recovery from the last recession far from complete and companies still running lean, the initial conditions for widespread cutbacks – a central part of previous recessions – is absent.
• Labor cost inflation will remain benign. Elevated unemployment will continue to restrain labor costs which represent 70 percent of firm costs. Just released data reinforce this read: real GDP growth of 2.5 percent on a seasonally adjusted basis, nominal of 5 percent, while unit labor costs fell by 2.4 percent.
• Rising dividends. A notable development of late has been the large number of firms instituting or raising dividends. As long as equities remain cheap and corporate cash flows strong, dividends will continue to be raised. Investors have been paying a premium for high dividend stocks and an overall increase will support the market multiple.

All in all, therefore, the outlook is good on prospects for US equities in 2013.

The recommendation is to overweight the domestic cyclical sectors (financials, industrial, tech, discretionary) versus defensives (staples, healthcare, telecoms, utilities). The domestic cyclicals massively underperformed the defensives in 2012 from February through the early October bottom in equities, but have been recovering strongly with the market.

European Equities

The key question for investors in European equities is whether to switch from the defensive stocks that have served them well in the global crisis to cyclical stocks.

Classic defensives such as Nestlé are  on PE multiples of 17 times or so while some cyclicals such as Rio Tinto are trading at just eight times.

The difference between the PE multiples of defensives and cyclicals is now more than 6.5 times, the same margin as the final quarter of 2008 when the global crisis was at its height. The time is now right to make the switch to cyclicals.

First, the threat of a global recession is easing with the US economy looking healthier and Chinese risks looking less negative than before.

Though there have been flat to modestly softer margins, this does not pose a significant threat since the bulk of the increase in margin expectations since 2010 have not been priced into the market because of concern over their sustainability.

Second, debt levels at many European companies are low and cash levels are high so there is scope for dividend increases and/or buybacks and special dividends. Buybacks in the U.K. for example should finish 2013 at more normal levels (1 percent of market cap).

The preference for cyclicals does not extend to financials, however. While banks look cheap and may recover in the short term, they face a headwind of weaker Eurozone growth, dividend cuts and question marks about their long-term returns.

The downside risks are especially pronounced in France and Italy where an avoidance of consumer related stocks in general also seems sensible. Stocks with a high exposure to government spending are another subset of domestic stocks that continues to look vulnerable.

The best opportunities will be found in globally exposed cyclicals which sold off dramatically in the summer of 2012 and now look undervalued. It is important to remember that European stocks are not plays on whether or not there is a solution to the sovereign debt crisis.

Underweighting or overweighting Europe relative to other regions is really about global growth and whether European stocks are a cheaper route into that growth.

Asian Equities

Asian equities are likely to underperform developed market equities in 2013 just as they did in 2012. While bouts of reflationary expectations in the US, Europe and especially China are likely to lead to periodic rallies, the underlying dynamics in Asia are challenging.

A focus on large-cap stocks with inexpensive valuations (especially dividends), solid balance sheets and analyst support is the way to generate relative returns. Countries that have underinvested – Korea, Thailand and the Philippines – have pockets of value.

Growth investors should focus on the projected growth in middle-aged and older folks in Asia – financial services (not banks), luxury goods, travel and entertainment and upper-end healthcare look promising.

The expected contraction in youth cohorts (except in India and the Philippines) is likely to pose a challenge to technology and internet stocks. A more disorderly slowdown in China, a consequence of a policy error, is likely to pose a threat to the decade long bull market in base materials and industrial cyclicals.

There are three key reasons why Asian equities are likely to underperform developed market equities.

• First, Asian equities have little or no valuation advantage over developed equities. As an example, the free cash flow yield for the four key regions. Asia ex-Japan has paltry FCF yields of around 3 percent, compared with 6 percent each for the US and Japan, and 9 percent for Europe.
• Second, the relationship between nominal GDP growth and EBIT margins has broken down around the world. Spain and Italy have higher EBIT margins than most of the ‘growthy’ emerging markets.
• The third key reason is the fact that the US dollar is at its lowest levels since the breakdown of Bretton Woods. Any rise in the USD versus a basket of currencies is normally bad for Asian/emerging market equities.

So, both on a cyclical and structural basis, Asia’s margin power is likely to suffer this year. This problem is likely to turn acute in China, where the productivity of incremental credit expansion is falling and poor investment is already leading to an erosion in profit margins.

Only a world-record beating rise in sales growth (compared to the asset base of firms) or a rise in financial leverage can mitigate the decline in profit margins.

A global reflationary package, monetary or fiscal, would likely lead to a rally in Asian equities. A reflation in China would be especially powerful for regional equities. A shift from bonds into equities by institutional investors, attracted by relative valuations would also be beneficial to Asian equities.

Domestic pension funds in the region are severely under-invested in the equity asset class and a policy or regulatory shift here would have a substantial positive impact. A drop in regional inflation, would lead to lower interest rates and be helpful to Asian equities.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2013 Oseme Group