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

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