By Ineke Valke, Senior Investment Strategist, Theodoor Gilissen, a member of KBL European Private Bankers
The 2015 outlook for equities – supported by favorable economic policies, a narrowing output gap and ongoing profit growth – remains positive, especially compared to expected yields on other asset classes. The US and Japan should both outperform, while listed real estate continues to appear satisfying.
Over the past several years, equity prices have decoupled from the global economy, far outpacing the rate of macroeconomic growth. Moving forward, we expect that trend to continue, although returns may be below historical averages – particularly as market volatility increases. Given that the global economy is expected to witness continued expansion in 2015, we see little risk of market collapse.
In fact, there are additional underlying factors that should continue to support equities, including increased M&A activity, a lack of high-yielding alternatives and the further strengthening of the US dollar.
Indeed, although bonds and equities are both inversely correlated to interest rates, the relationship tends to be stronger with the former: while bond prices almost always fall when interest rates rise, equity prices do not necessarily behave the same way. Equities tend to be well-suited to dollar bull markets, so we anticipate that equity markets will strengthen throughout 2015 along with the dollar.
For 2015, we have a preference for US and Japanese equities, although this view may need to be revisited over the course of the year due to changes in valuations and overall momentum, including potential surprises from Japan.
US equities have outperformed for six of the last seven years, but we still see room for further outperformance. Given the low recovery rate following an unusually severe decline, the US business cycle remains in its initial growth phase – even though that cycle is now entering its sixth year. Meanwhile, American firms will continue to benefit from sustained US GDP expansion, which we forecast to reach 3% in 2015.
Historically, US equities trend in four-year cycles, with the strongest performance during the third year after a presidential election. (As the last such election took place in 2012, this provides further, albeit anecdotal, support for our bullish view on US equities in 2015.)
A number of analysts have pointed out that, as profit margins at US firms are high by historical standards, they will inevitably decline over the next 12 months. It is true that margins have been steadily climbing since 2000 – with the exception of one very steep decline in 2010 – and we agree that a slight decline is possible in 2015, exacerbated by the strong US dollar. However, given current cost controls and efficiencies, we believe that US corporate margins will generally hold up.
As mentioned earlier, we are also positive on Japanese equities. Increased support from the BoJ combined with decreases in corporate tax rates are key factors in that regard. At the same time, labor costs continue to decline by more than 4% annually, as pricey full-time workers are retiring and being replaced by younger, less-expensive and/or part-time staff.
Recently, Japanese companies have generally chosen to expand margins and profits – rather than increase market share. That is primarily because Japanese exporters have not yet adjusted dollar-linked prices downward in line with the falling yen.
Indeed, since the start of 2013, profits on the Tokyo Stock Price Index (Topix) have risen nearly 50%. As exports are likely to continue to improve, companies could realize satisfying profit growth of 13% in 2015.
It is also important to note that the GPIF, Japan’s massive state pension fund, will increase exposure to Japanese equities in 2015.
In that regard, the GPIF will be tracking the newly launched Nikkei Index 400, which focuses on companies with good corporate governance and high and recurring profitability.
Overall, however, profitability levels remain low in Japan, as does labor-force productivity, which stands at some 40% below the level of France on an hourly basis. Japanese companies also have the world’s highest level of operating leverage – due to the cost of both fixed expenses and the country’s inflexible workforce.
Compared to other advanced nations, Japan’s corporate sector also has extremely high cash holdings as a percentage of market capitalization; while that provides a cushion against potential shocks, it is also serving as a drag on the economy, as insufficient liquidity is being unlocked for investment.
That said, Japan boasts a high level of innovation, and return on equity is improving. Dividends are also increasing, while valuations remain attractive, offering a 10% price-to-earnings (PE) discount to US equities.
We have identified two equity styles that we believe will prove especially appealing in 2015: first, stable, high-dividend companies, particularly from the eurozone; and second, large caps, with a focus on companies with strong price-setting power.
The former category – stable, high-dividend firms from the eurozone – already offers significant spreads, which will likely remain wide moving forward.
As well, eurozone-based, high-dividend stocks are trading at a discount to the overall market – partly a consequence of value traps due to recent dividend cuts by telecom and utility companies.
Meanwhile, major listed firms with dominant market share will benefit from increasingly favorable macroeconomic conditions in 2015. Indeed, during a period when small caps are trading at considerable price-to-earnings premiums, we see special opportunities in such large caps.
In 2015, European companies, half of whose sales are made outside Europe, are likely to benefit from a lower euro. Such equities should likewise profit from an undervalued currency, given that a 10% decline of the euro against the dollar provides additional 8% growth in earnings per share.
An improvement in the US will prove a further benefit, though with a time lag. Nevertheless, we maintain a neutral position on European equities in 2015.
The declining eurozone growth outlook is one of the main reasons for our caution. We also expect earnings estimates to be adjusted further downward, as the profitability track record of European companies remains far from convincing.
Over the course of 2015, as macroeconomic growth rates start to pick up, our view on European equities is likely to become more positive: Europe can outperform when the euro weakens or inflation rises. This could be a trigger for a re-rating of corporate profitability. Moreover, dividend yields remain attractive vis-à-vis bond yields.
EMERGING MARKET EQUITIES
Our position on 2015 emerging markets equities is also neutral.
A range of emerging-market countries are being hit by reduced energy exports to the US. This has led to increased inflation (which will accelerate if the dollar rises further), additional state spending on dollar-denominated subsidies and lower commodity prices. At the same time, however, commodity importing EM countries are benefiting from those low prices.
Across the EM universe, unit labor costs have been increasing faster than in developed countries, leading to a deterioration in emerging market labor expenses and, more broadly, a decline in the competitive advantage of this broad region of the world. At the same time, too few EM countries and companies are successfully transitioning away from manufacturing.
Emerging market equity indices are similarly marked by a lack of diversity, with too much energy, materials and industry. An additional drag on profits is the fact that the non-working segment of the population is rising faster than the working age population.
We therefore view EM equities as less attractive than US, Japanese and even European shares. However, there are at least two notable exceptions to this view: India and China.
India, a commodity importer, is set to benefit from a range of government-led reforms and, of course, lower oil prices. In turn, Indian consumers will see a rise in disposable income rates, supporting the country’s nascent equity market.
China is in the midst of a major shift away from industrial production towards services, and is also now tackling corruption. These changes will dampen short-term growth and could lead to shocks. To avoid a hard landing and attendant social tensions, Beijing has injected a series of what the state terms “mini-stimulus” measures over the course of 2014.
More important for Chinese equities is further reform and diversification of the country’s capital markets, which is positively impacting both foreign and domestic investors. Consequently, China’s weighting in emerging market indices could be boosted, triggering additional investment.
LISTED REAL ESTATE
We remain positive on the outlook for global real estate. Quantitative easing continues to support asset-price inflation, and property as an asset class will benefit from this ongoing trend.
Over the last several years, construction activity has been sluggish. As a consequence, especially in markets such as the US, UK, Canada and Australia, real home prices are now accelerating at healthy levels. (That said, prices continue to decline in markets like France, Spain, Italy and Japan, reflecting underlying structural concerns.)
Globally, however, sectoral supply and demand are increasingly at equilibrium, thanks to lower unemployment levels and higher income growth, as well as a balancing of affordability rates.
Moving forward, gradual macroeconomic improvement will lead to a concomitant increase in demand – and higher prices. Already, transaction volumes are recovering, and both rents and prices are rising.
Today, dividend yields for real estate companies are very attractive compared to bond yields. Such dividend payments are likely to increase in future, including by at least 8% for listed property companies in the United States.
However, when central banks start hiking interest rates (and interest yields begin to rise), the market may react negatively.
We believe that such a scenario is nevertheless not imminent, and expect monetary policies to remain accommodative in the near future, with yields rising only modestly over the same period.