Published December 27, 2012
We hope 2013 will be the year for equities -- the investment world has been chasing yield over the past two years. While we understand the income concept in a decade where equities have failed to keep pace, in our opinion this has resulted in warped equity versus bond valuations.
We are not value investors -- we prefer to invest in companies with the best growth profile and then decide what we are willing to pay for it. But this focus on yield has pushed valuations for U.S. equities to levels where we feel compelled to highlight value as a theme for 2013 and beyond.
Next year is likely to be another year of moderate company earnings growth (in the 5-10% range) aided by a bounce in some emerging markets and steady, albeit slow, growth in the U.S. economy. In other words, a ‘Goldilocks’ scenario: not too hot, not too cold. This should be enough for equities to produce a positive return given current valuations. In a better macro environment, these valuation levels would traditionally support double-digit returns.
2012: Macro Worries Finally Taking a Backseat
Macro worries didn’t dominate investor sentiment in 2012 in the same way as 2011. Of course, liquidity certainly helped. The Long-Term Refinancing Operation supported a significant rebound in equities globally at the start of the year and both the Fed and the European Central Bank came in to support another round of quantitative easing in September.
More importantly for active managers such as ourselves was the fact that correlations between asset classes as well as stocks within the S&P 500 have fallen significantly, giving stock pickers an advantage.
We would not be surprised to see a difficult time for the market in the first quarter if Hurricane Sandy, fiscal cliff concerns and election-hangover cloud fourth quarter 2012 data. However, we expect a positive return over the year. Our base case for 2013 is another year of moderate growth in corporate earnings aided by a bounce in some emerging markets and slow, steady economic growth in the U.S. This will be supported by liquidity and the Fed’s dual mandate, a strong corporate sector, and consumers benefiting from a stronger balance sheet and potentially higher levels of employment.
What is becoming increasingly clear to those following the U.S. is that the housing market, which has been a drag on growth for a very long time, is on the cusp of turning. We think the benefit of this is significantly underappreciated by investors given the multiplier effects it could have on the economy. We are also in the camp which believes that the employment picture should improve as the year progresses -- GDP levels are improving, but the U.S. workforce is achieving this with 4-5 million less jobs. We think this is unsustainable.
Of course, we are still watching the risk around the fiscal cliff and confidence at both the consumer and corporate levels; the recovery is very fragile. But these worries are reflected in the market.
Despite this, there has been no increase in flows into equities yet. We hope this can change in 2013. Bonds are now at levels that will make a positive capital return more challenging.
Valuations Support Long-Term Returns
Over the past 20 years, the S&P 500 has usually traded in the 10-20X range on a forward price to earnings (P/E) basis, with an overall average of approximately 13.7X. Our view for next year’s earnings growth of approximately 5-10% lowers the P/E ratio to less than 13X. Historically, this has yielded double-digit upside for stocks. Investing in period of low P/E multiples has traditionally yielded more return.
While other developed markets could be ‘cheaper’, we view the U.S. market as very attractive given prospects for GDP growth, support from the Fed’s dual mandate and the secular growth drivers we highlight below.
Valuations are even more interesting when looking at equities relative to bonds, where positive capital return looks more challenging at these spread levels. Of course, this is a situation that could persist for some time, but for long-term investors, we believe the upside opportunity is significantly higher in equities over bonds.
Deleveraging Risk Remains, But the U.S. is in the Best Position
The largest risk is company deleveraging, but we find some solace in the fact that the U.S. has dealt with a number of these challenges already. Companies, and especially banks, already have healthy balance sheets, positioning cash returns for growth opportunities and return to shareholders.
We feel that company balance sheets will continue to be repaired as the benefits of a pick-up in consumer spending, an improving employment picture and a housing recovery in 2013 come through.
What remains, and we recognize that this is a risk, is government curtailments. What positions the U.S. differently here is the prospect for long-term GDP growth -- it is likely a lower debt picture is driven as much by the equity base growing for the federal government as by spending cuts.
In this respect the U.S. is better equipped for dealing with federal fiscal challenges than other developed markets because the U.S. economy has the best chance of actively growing. This belief makes us champion U.S. equities as a base for most investor portfolios for the next five years.
What investors seem to forget is that the U.S. has a number of competitive advantages and longer-term structural changes that should support U.S. growth relative to other countries.
While trends are evident on a global basis, many of the world’s largest, most recognizable brand names – and most innovative companies (Apple, Google and Amazon) reside in the U.S.. This provides a solid foundation for organic revenue growth and expands the breadth of investment opportunities for our growth-focused strategies.
The U.S. market has experienced a significant shift in its competitiveness driven by a weak dollar, rising labor productivity and energy technology (allowing the U.S. to become less dependent on international energy reserves). In addition, cost escalation in emerging markets has made the U.S. a less expensive relative bet. As a result, the U.S. is seeing resurgence in its manufacturing base and a greater ability to support its long-term GDP growth potential.
In contrast to other developed economies, the U.S. still has real population growth which should support the long-term growth of the economy and help it deal with some of its challenges, such as the housing market overhand. This trend is being driven by both a positive birth rate and immigration.
Joanna Shatney is head of U.S. large cap equities at Schroders.
The views and opinions contained herein are those of Joanna Shatney, head of U.S. large cap equities, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients.