Too many bulls; not enough beef

Since fears about the survival of the Eurozone and potential recessionary impact on the world economy reached a height in September 2011, stock markets around the world have performed strongly. For example, the MSCI World Equity Index has risen by 50% in US Dollar terms. However, this global bull market has been almost entirely driven by rising valuations, rather than by earnings growth. Valuations of many equity markets are now back at the high levels seen in 2006-07 and, in the absence of earnings growth offer limited upside for stocks.  We do, however, see scope for valuations to rise in Asia and Japan, and have most confidence in the earnings outlook of Japan and the UK – these markets are our preferred areas for equity investment. Conversely, the European and US markets are likely to underperform on a relative basis over the next few quarters.

The most commonly used valuation tool by investment analysts to analyse shares is the Price-Earnings ratio (“PE”) – the share price divided by the earnings per share (“EPS”) of the company. The lower the PE, the cheaper the share is considered to be. A share price is likely to rise if the company’s earnings grow, or if investors expect increased earnings quality in the future – this is reflected by the PE rising. Over the long term, EPS can be expected to rise in line with the growth in the global economy, while the PE tends to be mean-reverting around long term norms.

Too many bulls

Since 30 September 2011, the point of greatest concern that a collapse of the Euro might trigger an even deeper world recession, the MSCI World index has risen in price by about 50% in US Dollar terms (about 40% in Sterling). The table below breaks this performance down between the change in forward EPS and the change in forward PE, across the different regions of the global equity market.

  Analysis of MSCI Index performance during the 30 months from 30/09/2011 to 31/03/2014
Index Price Forward EPS Forward PE Forward PE Forward PE
  % change % change % change Level on 30/06/2007 Level on 31/03/2014
MSCI Asia ex Japan $ 24.4 2.4 21.5 15.0 11.8
MSCI UK £ 27.8 -12.9 46.7 12.7 13.0
MSCI Japan Y 58.6 38.5 14.5 18.2 13.3
MSCI Europe ex UK € 49.1 -8.8 63.5 13.6 14.3
MSCI US $ 65.9 11.4 48.9 15.4 15.7
MSCI World $ 51.6 2.8 47.5 14.9 14.8

Source: MSCI, Thomson Reuters.


Column A – MSCI Index

Column B – % price change in Index from 30/09/2011 to 31/03/2014

Column C – % change in Index Forward Earnings Per Share (next 12 months)

Column D – 100 x (1+B)/(1+E) – % change in Index Forward PE

Column E – Index Forward PE on 30/06/2007

Column F – Index Forward PE on 31/03/2014




The table shows that the forward EPS (that is the forecast earnings over the next 12 months) of the MSCI World Index rose by only 2.8% over this 30 month period, but that there was a 47.5% gain in the PE, so the bulk of the gain in the index price was due to increasing valuation. This was most marked in Europe, where the PE expanded by 63.5% (though at the beginning of the period Europe was extremely cheap as it was at the height of the Eurozone crisis), and in the US, where the PE expanded by 48.9%. The Asian and Japanese markets, by contrast, have seen the least PE expansion.

Column F in the table above shows the current values (at the end of March 2014) of the Forward PE – the US and Europe have the highest valuations, while Asia, Japan and the UK have the lowest valuations. Comparing the forward PEs today (Column F) with their levels at the end of June 2007 (Column E), the valuation peak before the financial crisis and the last period of general market bullishness, suggests that valuations in both Japan and Asia are lower than those in 2007 and therefore still have scope to rise. However, the PEs for the US and Europe are higher than their 2007 peaks and appear to have little scope to increase further without moving into clearly over-valued levels. Thus earnings growth is now required if further sustainable gains in these stock markets are to be delivered.

Not enough beef

Over the long term, equity markets rise with the growth of the economy and in particular with corporate profits. Earnings growth is the “beef” that markets require to move sustainably higher. Of the global equity market regions, the US has experienced the strongest economic growth over this period, corporate profit margins are at their highest ever levels and companies have been very aggressive in their use of share buybacks. Yet, even with all these positive factors, forecast earnings have only risen by 11.4% over the 30 month period.

The weakness of the European economies is highlighted by the decline in forward earnings in both the UK and Europe. Some of this can be attributed to recent currency strength, but most of the weakness reflects the lack of demand in the European economy in particular. Japanese forward earnings fell through 2012, have risen sharply since 2013 as “Abenomics” was introduced, but are up only a little over the whole period. Japanese forward earnings are however rising at the fastest rate of all the regions.

We have the most confidence in the immediate earnings prospects for Japan and the UK, which is where we expect to find the beef. In Japan, the weakness of the Yen and the increasing likelihood of wage gains helping to increase consumer spending should continue to improve the corporate earnings outlook. In the UK, the domestic economic recovery is expected to boost the earnings of small and mid-sized companies. Meanwhile, large companies are very sensitive to the exchange rate and their earnings should see a significant boost if the recent spate of currency strength reverses.



Though we expect equity markets to deliver better returns than bond markets this year, we anticipate greater volatility than seen during the last two years.In the longer term, we remain convinced that Asian economies will deliver the greatest growth of all the regions and that this will feed through in EPS growth for Asian companies.   Our model portfolios remain underweight equities in the US and Europe-ex-UK and overweight in Asia, Japan and the UK.

A Stagnant Europe

The outlook for returns from European shares for the next few years is not exciting, though the level of dividend yields is likely to support current prices, thereby limiting the downside risk in these markets.   The investment implications are to remain VERY LIGHT in European equities, where domestic growth is expected to be disappointing and exports outside of the Eurozone are likely to remain under pressure from a strong Euro.

As in the US market, the earnings growth in the Eurozone for 2014 (that is already expected by analysts) is strong, despite the lack of revenue growth expected from most companies. Further, again as in the US, the valuations on these optimistic earnings forecasts are at the high end of the normal range. Core European bond yields are likely to remain low but risks certainly remain in peripheral bond markets.   Political developments need to be monitored closely for any indications that the rise of the anti-EU factions in the peripheral countries begins to change the current support within them to stay in the Euro.

The EU parliamentary elections – According to the opinion polls, the anti-EU, UK Independence Party (UKIP) could emerge with the most votes in the UK’s forthcoming elections to the European Parliament. This apparent rise in nationalist sentiment is not just a UK phenomenon, with the French National Front, Italy’s Forza Italia, Greece’s Golden Dawn, and the Freedom parties in Holland and Austria all scoring highly in opinion polls. Though these disparate parties do not all get on with each other, it is possible that they could, between them, win about 20% of the seats in the new Parliament. This is not likely to be enough to change the path towards greater integration within Europe, but is enough to be a very vocal nuisance within European politics.

Austerity – The peripheral economies (generally understood to be Spain, Portugal, Greece, Cyprus and Italy) have undergone harsh austerity in recent years, leading to very high levels of unemployment (and youth unemployment in particular), in the cause of remaining in the Euro and receiving support from EU bailouts and the ECB. It is perhaps surprising that anti-EU sentiment is not even greater in these countries, but there appears to be a grudging acceptance that the German-prescribed policies of economic orthodoxy must be adopted. These are (i) lower government spending and (ii) smaller budget deficits together with (iii) lower wage levels to regain competitiveness. The stark alternative for these economies is to come out of the Euro and allow currency depreciation to ease their problems, by creating inflation and reducing living standards. Even France, led by a Socialist president, has now succumbed to German orthodoxy on its budget, acknowledging that its levels of taxation and budget deficit cannot be allowed to go any higher, and that spending cuts are necessary.

There are however, two problems with extending the German approach to economic policy to the whole of the Eurozone. First, most of the Eurozone’s exports are to other Eurozone countries, so reducing domestic demand through austerity in one part of the Eurozone merely reduces export demand for the rest of the Eurozone. Second, the peripheral countries’ greatest need is to regain competitiveness against Germany. This would be much easier to achieve if Germany were prepared to become a little less competitive, by having some price and wage inflation. A few years of German inflation at 4% with 0% inflation in the periphery would ease the Eurozone’s problems considerably. However, if German inflation remains at 2%, then inflation at –2% might be required in the periphery; economically such deflation is particularly harmful, keeping unemployment and budget deficits high.   There are few signs that Germany would be prepared to tolerate a 4% inflation rate.

Following the Japanese – The Eurozone is currently edging towards deflation, with the current inflation rate at 0.8%. With its other issues of ageing populations, high levels of government debt and high welfare spending, it shares many similarities with the Japanese economy of a decade ago. There, the economy has, until very recently, been mired in a long period of economic stagnation in which the nominal size of the economy has not changed – there has been some real growth, but this has been offset by falling prices and wages.

Stagnation – Our concern is very much that the Eurozone, following orthodox German policies, with an absence of stimulus from fiscal policy or from monetary policy and with an ECB extremely reluctant to implement QE, may have entered a period of structural economic stagnation, with high levels of unemployment, similar to the experience of Japan. This would be negative for economic activity and indeed for social cohesion in the weaker economies, and, in time, the support for the anti-EU parties may be strong enough to lead to more radical change than the forthcoming elections are likely to create. This might mean a change to policies that were incompatible with continued membership of the Euro.

Just as the UK’s exit from the Exchange Rate Mechanism in 1992 and sharp fall in Sterling marked the start of a new period of growth in the economy and a new bull market in stocks, any country that did exit the Euro would be likely to derive the same benefits. However, for now, continued adherence to the orthodoxy of German economic policy ideas is expected to lead to a period of economic stagnation for the Eurozone economy.

This time IS different for equity markets

Observant investors over the last 30 years should be looking at the current markets and thinking that an opportunity to buy into equity markets may be at hand. Following some inflation fears in 2010 and 2011, inflation across the world has declined markedly in 2012 and looks set to decline further to levels below the targets that Central Banks have set. Further, economic growth is slowing markedly and has now become a greater economic and political risk than inflation. Policymakers’ focus has clearly shifted from concerns about inflation to concerns about growth. Historically this shift in focus (1982, 1988, 1992, 1998, 2002 and 2009 saw similar shifts) has been a clear BUY signal for equity markets – in today’s conditions this is further supported by very low valuations on equities.

In these previous cycles, the shift in policymaker focus led to substantial policy easing, principally via lower interest rates, which boosted consumer disposable income, boosted consumer confidence and encouraged demand for mortgages for house purchases.  This led consumer demand as a whole and thus an economic recovery. Equity markets rallied as they foresaw this pattern of events.

Sadly, however, this time is different. Policymakers certainly wish to boost demand by policy easing but the key differences this time around are (i) interest rates are essentially at zero and cannot be cut meaningfully, (ii) government deficit and debt levels have reached levels that terrify even the politicians and so fiscal policy has been neutered, (iii) the financial system is so badly damaged from its period of excess up until 2007 that it is no position to start lending again despite heavy political pressure, (iv) consumers now feel that in aggregate they allowed their debt levels to rise too sharply and wish to lower them and (v) consumer confidence in their economic future has been so badly damaged that many do not wish to borrow anyway.

The only policy stimulus open to governments and Central Banks is further Quantitative Easing (“QE”) or money printing. So far all the extra money that has been created has remained in the financial system and not found its way into the real economy – this is not to say that QE has been useless; it has not.  Indeed the financial system and the Western economies would be in a far worse state today if there had been no QE.  In addition, the long-running Euro saga has meant that the Eurozone has had to adopt very restrictive fiscal policies in an attempt for the weaker governments to maintain support from the markets and from the stronger Euro members, making the Eurozone economy much weaker than it needed to have been.

So this time, the usual cycle of policy easing leading to consumer recovery and thus economic recovery together with improving equity markets is unlikely to occur.  It is true that equity markets are cheap by historical comparison, and this should limit the downside potential for equity markets in the absence of a severe recession which would damage earnings. However, equities lack the usual reasons for investors to buy them, and so upside potential is also limited until some shock or crisis leads to a radically different policy approach.