A number of factors make us more confident in our investment call that equities should outperform bonds over the medium term:
Cut rates
Central banks finally got it and cut interest rates sufficiently to generate a recovery in their respective regions. The recent rise in the long-term bond yields gives something of a confirmation signal from the markets that this policy is generating some growth. Indeed, in recent weeks, economists have increasingly argued that the next move in interest rates from the US Federal Reserve will be up, and potentially before year-end. In Europe, some are arguing that the European Central Bank has finished its easing cycle.
Fiscal policy both in the US and Europe has been more urgently used by governments. The latest tax changes in America puts money into consumers’ pockets this summer in the hope that they spend the majority of their dollars.
In Europe, the latest relaxation of fiscal policy in the eurozone will provide a significant boost in the coming 18 months and reinforce nascent economic growth.
With the benefit of low interest rates and easier fiscal policy, recent economic data has confirmed that the US economy is well into its recovery. Cuts in taxes are supporting this, generated at least in part by substantial cuts in interest rates.
Most important, the US economy has at last cleared some of its imbalances. Capital spending has been savagely slashed and corporates are finally generating significant amounts of cash. Confidence amongst industrialists and consumers is up strongly and looks likely to rise further. In the service sector, industrial confidence hit an all-time-high last month.
In Europe, growth appears to be recovering from its post-Iraq low helped by easier fiscal and monetary policy. Consumer spending in particular has shown a consistent recovery in recent months. Economic growth in Japan has surprised to the upside and looks likely to show the most consistent improvement for a number of years.
The pick-up in equity markets over the last three months is partly due to signs of recovery in corporate profits. The last two corporate results seasons in the US have seen analysts falling over each other to upgrade their forecasts in the light of better-than-expected quarterly results.
Results forecast
Even in Europe, corporate profits forecasts appear to be on their way up. We are only a third of way through the second-quarter results season, but the number of companies beating analysts’ forecasts is running at three times those companies missing forecasts.
This good news on corporate profits is in sharp contrast to the big black holes witnessed in company profit and loss accounts in recent years.
After a protracted bear market in equities, it’s easy to forget what the enduring attributes of equities in any portfolio are meant to be. It is not just the last three years that have been extraordinary in the equity markets. Indeed the extraordinary period probably dates back to 1997, or before the worst of the tech bubble, and it is therefore some years since investors saw a normal year in equities.
Equities should give investors a sufficient premium return over the longer term to compensate for the extra risk of stocks relative to bonds and cash – the so-called equity risk premium. A simple rule of thumb: over the very long term, equities should give a return in line with that of economic growth. In the case of the US, economic growth in nominal terms (including the effects of inflation) should trend at around 6 per cent over the medium term. When combined with the dividend yield on equities of around 2 per cent, this gives a longer term return on equities of some 8 per cent.
Whether equities can give investors a greater than normal return in the very near term, however, depends on whether equities are viewed as cheap or expensive relative to an assumed fair value.
We believe that US equities are already fair value and hence longer-term returns should be in line with economic growth. In the case of Europe and Japan, we believe that these markets are fundamentally cheap – perhaps by as much as 30 per cent – which gives a further potential return over and above the longer-term “normal” growth.
Whether our theoretical returns from the markets are achieved depends on enough investors seeing the opportunity in the equity market and investing in it.
There are signs that investors around the world are coming back to the equity market in numbers. Recent US mutual fund data shows that retail investors are buying equities at a pace. The last three months has seen an average inflow into equity mutual funds of close to $4bn per week. In just the last few weeks those inflows have touched $10bn.
Healthy interest
Although the level of subscriptions is down on the heady days of the bubble, it still represents a healthy interest from investors who had been badly burned before.
While not yet on a par with the US, mutual funds sales in Europe have picked up and are back to the healthiest levels seen in some months.
Equally, institutional investors have returned. Recent surveys of institutional investors show a very high level of interest and confidence in equities. If these levels of interest develop into consistent demand, equity markets can continue their rehabilitation from the worst period in some 75 years.
Gary Dugan, global market strategist, JPMorgan Private Bank
