There have been some impressive rebounds in developed world equity markets since their lows in the December quarter, writes Bob Van Munster, Head of Equities for Tyndall AM.
For example, the S&P 500 is up 17% and the German DAX is up 18%, Australia is up a moderate 6% – with Australia’s underperformance reflecting a lag in earnings.
Despite these recoveries, investors have low conviction on the short- and medium-term directions of equity markets. This lack of conviction is reflected in anaemic trading volumes as investors try to assess:
- whether the Euro-zone debt crisis has stabilised or it will worsen
- if US growth is sustainable or it will track the same path as the past two years
- or if China can sustain its enviable economic growth track record or is it at the beginning of a property bubble bursting?
The consensus view is that risks are skewed to the downside and therefore capital preservation is paramount, even if it requires negative bond yields like the recent German bond auction. The bulls point to a number of factors, primarily valuation, high cash holdings and easy monetary conditions. The bears gravitate to global debt deleveraging, earnings downside risks and economic and geopolitical tail risks.
The bears’ view of the world is reflected in the Australian equity market not only through low PEs but through the significant PE premium that defensive stocks have over cyclical stocks (circa 13 times forward earnings versus 10 times for cyclicals). The premium for defensives is at levels not seen the since the height of the GFC, which was prior to a significant reversal in March 2009. To push these ‘premiums for safety’ even higher requires a further loss in faith in the long-term earnings potential of cyclical sectors.
Economic growth is set to slow in 2012 globally, but the market appears priced for this. If a global recession can be avoided, the equity market could stage a healthy recovery in 2012. Why? We believe the market is now pricing in a significant amount of bad news and earnings risk. If further bad news does not eventuate to the extent the market is factoring in, then there will be relief rallies that could see markets materially higher by year end.
Obviously, we need to play the economic cards as they are dealt as the risks are still high. Europe appears to be playing a high-risk game of forcing economic austerity on recalcitrant countries whilst avoiding the moral hazard of priming the European economy until economic stability is achieved. The risk is a significant negative economic spiral if there are any mis-adventures in the form of policy errors on the way. In this context, the macro environment was the key driver that weighed down markets in the second half of 2011. High volatility and high correlation of asset returns occur in bear markets.
These are generally not conducive to active managers producing alpha, but if markets and economies can stabilise, then asset correlations and volatility generally declines and active management can be allowed to add value. I would argue that a lot has already happened in Europe, China and the US and as such markets have factored in too much risk.
As value managers we search for value. However with domestic cyclical stocks suffering from a combination of the two-speed economy, high $A and structural changes such as the internet and changing consumer patterns, investors need to be discerning of whether the value is real or illusory. At this point, it is very difficult to determine how much of the earnings malaise can be attributed to cyclical vs structural issues. We believe our in-depth internal analysis gives us a competitive advantage here. There will be opportunities where investors will throw the baby out with the bath water.
Our portfolio is orientated to stocks where we believe cyclical issues are greater than negative structural issues: these include stocks like Henderson, Aristocrat, Qantas and James Hardie. We are overweight cyclicals as these are significantly cheap when looking at mid-cycle earnings, which is the chief value metric we use. We also hold some relatively inexpensive defensives to counter-balance the portfolio in case the world economy’s structural woes deteriorate further. In this space we like Duet and Telecom Corporation (NZ).