Key points
- Share markets and related trades such as commodity prices and commodity currencies have fallen over the last two weeks, partly triggered by worries about the impact of Chinese tightening and the re-emergence of sovereign debt problems in Europe.
- However, this is likely to be a correction in an ongoing cyclical recovery in shares: the global recovery looks like it is continuing, shares are still cheap, the liquidity backdrop for shares is positive and a cashed up corporate sector is likely to lead to increased capital being returned to shareholders.
Introduction
After solid gains from early July lows into early November, shares and related trades such as commodity prices and the Australian dollar have fallen sharply, as renewed worries about sovereign debt in Europe and more pressure to tighten in China have led to renewed worries about the global growth outlook. Our assessment is that this is just another correction in an ongoing cyclical recovery in shares. This note looks at why, and what the key threats might be.
Cyclical dynamics remain positive
After the strong gains in recent months, growth trades such as shares and commodities had become overbought and due for a correction. This is what we have seen over the last week or so with worries about another round of sovereign debt problems in Europe and more tightening in China being the main triggers. This could have a bit further to run.
However, the broad cyclical back drop for growth trades such as shares and commodities remains positive.
First, shares are still cheap. Price to earnings multiples are well below long term averages. For example, the price to earnings ratio for Australian shares based on one year forward consensus earnings is 12.5 times against a long term average of 14.6 times. The grossed up dividend yield from shares at 5.3% is about the same as the 10 year bond yield meaning shares require only modest capital growth to provide a much better return than bonds. Forward price to earnings multiples on global shares are also around 12.4% times, which is well below longer term averages.
Source: Bloomberg, AMP Capital Investors
Second, there is reason to have greater confidence in the continuation of the global recovery. After falling around mid year, business conditions indicators appear to have stabilised in most major countries, with the exception of Japan. In fact, in the US, Europe and China they have turned back up after falling around mid year.
Source: Bloomberg, AMP Capital Investors
In the US, strength in the corporate sector appears to be driving a pick up in employment and capital spending, housing indicators appear to have found a floor and retail sales growth has been surprising on the upside. In Europe, strength in Germany and other northern European countries has offset weakness in debt impaired countries, Japan’s economic growth has actually surprised on the upside and China has had anything but the hard landing feared earlier this year.
Third, we are now seeing more monetary easing with another round of quantitative easing in the US (QE2) and a mini version of the same in Japan. This in turn is being transmitted into several emerging countries to the extent they have intervened to resist an appreciation of their currencies as a result of capital inflows from the US and in so doing are effectively boosting their own money supplies. Putting the criticisms of QE2 aside, a key objective of quantitative easing is to boost asset prices – as this will increase the net wealth of households and hence help consumer spending. To the extent the extra liquidity has to go somewhere, there is a good chance some of it will go into shares achieving its aims in this regard. This was certainly evident from QE1 last year.
On the liquidity front it’s also worth noting that over the last few years a wall of money has gone into bond funds. This could reverse at some time pushing up bond yields and resulting into a greater flow of funds into equities.
Source: US Investment Company Institute, AMP Capital Investors
Fourth, the corporate sector is cashed up. This is evident in surging profits at a time when business investment is coming off a low base. As a result the corporate sectors in the US and Australia are now net lenders, i.e. generating more cash than they are investing (see the next chart for Australia). This points to a further pick up in M&A activity, dividends and share buybacks going forward.
Source: Thomson Financial, AMP Capital Investors
This is clearly evident in Australia where takeover activity is building. Eg, no sooner has BHP had its Potash takeover knocked back than it is restarting share buybacks. M&A, increased dividends, share buybacks all have the same affect, i.e. putting cash into the hands of shareholders.
Finally, there are a number of cyclical dynamics which are positive for shares. The seasonal pattern in share markets is such that the next six months, i.e. November through May, is normally the strongest period for share markets reflecting the ending of tax loss selling for US mutual funds and new year optimism (see the next chart). We are also coming into the third year of the US presidential election cycle which is normally the strongest with an average annual gain of 19.4% pa since 1927.
So for all these reasons we think the cyclical recovery in shares has further to run.
Source: Thomson Financial, AMP Capital Investors
Potential threats
But what are the potential threats? There are several risks worth keeping on eye on:
- Ireland and Portugal have seen their bond yields rise to new highs and the size of the problem in Greece is still increasing, raising concerns about another European sovereign debt crisis. This is certainly a risk. However, several considerations suggest the impact may be lower than seen earlier this year as Europeans are now more aware of the dangers of delaying and backstops are in place: the European Central Bank can resume its purchases of bonds and troubled countries can tap the European Financial Stability Facility.
- In China, worries about policy tightening crunching the economy have returned after surging food prices pushed inflation up. However, t’s hard to see Chinese authorities getting too aggressive as non-food inflation is just 1.6%, economic activity indicators have cooled from earlier this year and Chinese shares remain cheap. That said, it may be a source of short term jitters.
- Bond yields in advanced countries are running well below long term sustainable levels and are at risk if some of the record capital flows of recent years reverse, perhaps in response to a run of stronger economic data, much like in 1994. The risk of this may be low now but is worth keeping an eye on next year.
- Similarly, the $US could stage a rebound on the back of stronger US data, making life tougher for US companies, commodity prices and commodity currencies like the $A. Apart from the current bounce from oversold levels, a sustained rebound in the $US looks unlikely given the additional quantitative easing in the US. It’s also possible that to the extent a stronger $US reflects stronger US and hence stronger global growth it may actually be positive for risk trades such as shares and commodity prices.
- Finally, the problems with mortgage foreclosures in the US could turn into another banking crisis. This seems unlikely but its worth watching out for any renewed leg down in US house prices and pressure on banks to repurchase mortgages from securitized trusts.
Conclusion
The latest set back in shares reminds us that the global recovery remains fragile. However, there are good reasons to believe it is just a correction in the continuing cyclical recovery that got underway in March last year.