Policy aligned for an upbeat year
Investors enter the New Year with renewed hope. Much of the economic and political uncertainty of the
second half of 2010 has been dispelled and optimism is spreading.
The last big weight was lifted from a fragile U.S. economy by Congress’s vote to extend all of the Bushera tax cuts. This move eliminates an apprehended drag on the economy from fiscal policy in 2011.
These developments in turn improve the outlook for North American equities over the next 12 months.
Both fiscal policy and monetary policy are better aligned for reflation of the economy.
More stimulus from Washington
In our view, politicians did the right thing by giving medium-term priority to growth over deficit reduction.
We see the program they adopted as necessary for getting the U.S. economy back on a sustainable growth path.
In addition to a two-year extension of the Bush-era tax cuts, the program provides a 13-month extension
of emergency employment benefits, a one-year reduction of payroll taxes and an accelerateddepreciation incentive for business investment. These measures introduced in addition to the tax-cut extension are likely to add about 0.5 percentage points to real GDP growth next year. Importantly, the plan removes the uncertainty that was weighing on households and businesses about their disposable income over the next two years. Moreover, it takes pressure off the Federal Reserve, which had been doing all it could on its own to give the economy traction.
QE2 ineffective?
The Fed began outright purchases of assets on December 13, buying about $75 billion in month one out of the $600 billion announced in November. Many fear that the purchase program is ineffective, citing the recent run-up in Treasury yields. We disagree. We read the recent bond sell-off as a vote of confidence in the sustainability of the recovery.
Inflation expectations, as gauged by the yield spread between 10-year Treasuries and 10-year Treasury
Inflation-Protected Securities (TIPS), have been relatively flat since the launch of QE2 (chart). In other
words, most of the rise in interest rates since November has been in real rates. We interpret this rise
as a repricing of U.S. growth expectations in response to fiscal stimulus that turned out more generous than
expected.
This interpretation is corroborated by the continued strength of equity markets. In our view, QE2 is not a
disappointment: the rise in bond yields has been more than offset by double-digit rises in equity indexes, for an overall easing of financial conditions. The Fed must be pleased by this development. As Mr. Bernanke put it November 4, “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending”.
Action breeds confidence
The boost to confidence from recent government and central bank actions should not be underestimated.
Surveys made before the stimulus package was passed suggest that sentiment on the economy was
already picking up. Both CEO and consumer sentiment indexes have risen in recent weeks (chart,
below). There is even improvement in the NFIB survey of small businesses, whose confidence has
lagged throughout the recovery period. The net percentage of firms expecting the economy to get
better next year is now the highest since June 2005.
This development suggests a tangible improvement in the job market.
VIX is contained, earnings are good
The current trend of the CBOE S&P 500 VIX index suggests that sentiment is also improving among
equity investors. At 17.6, the VIX is currently in a zone associated with an uptrending market and relatively strong investor confidence. Taken together with the good news of recent weeks, this coincident indicator augurs well for equity markets. The earnings outlook, already on track for continuing improvement, has gained further lift from Washington’s largesse.
S&P 500 earnings growth in Q4 2010 is currently estimated at 31%. Two sectors, Consumer Discretionary and Information Technology, are expected to report the highest earnings since Thomson Reuters began tracking the data in 1998. What’s more, the ratio of negative to positive preannouncements by S&P 500 companies for Q4 2010 is currently 1.7, below the long-term average of 2.0. In short, Q4 2010 is on track to deliver a fourth consecutive quarter of double-digit earnings growth, the best such run since Q3 2007. The improving earnings outlook has kept valuation reasonable. For the S&P 500, as the chart below illustrates, the ratio of price to 12-month forward earnings is currently 12.9.
The denominator of that ratio, the consensus 2011 earnings forecast, is 13% higher than estimated 2010
earnings. We think the extra stimulus provided by Washington makes this forecast plausible and have raised our 2011 EPS estimate for the S&P 500 to 97 (previously 91).
Global trends promote growth
Global growth in 2010 was driven by emerging economies. The industrial production of emerging countries is currently at all-time highs. In developed countries, meanwhile, growth has been less buoyant and industrial output has yet to return to the prerecession level (chart, below).
We think this trend, with China in the lead, is bound to continue.
Rising rates: The risk to equity markets is short-term
Strong growth comes at a price. Chinese policymakers face a need to normalize credit conditions in order to
keep inflation in check. Beijing recently raised its bank reserve requirement half a point, the sixth increase this year. At 18.5% effective, the reserve requirement is at an all-time high. Yet real interest rates in China are still very low, because the PBOC imports a slice of U.S. monetary policy by keeping the renminbi on a moving peg to the greenback. The very high reserve requirement notwithstanding, credit conditions in China are still highly accommodative.
However, as inflation gains momentum in the months ahead, a mix of higher real interest rates and, undoubtedly, a stronger currency will be required. Normalization of rates could crimp equity markets, since market participants will see it as a growth inhibitor. But investors should look beyond the short term of looming rate hikes to the prospect of a robust 8% expansion of the Chinese economy in 2011. In this perspective, China will continue to provide a solid foundation for global growth and earnings.
Asset mix: Raising the equity ante
The past 12 months have been challenging for investors. Financial markets have had to navigate major changes and significant headwinds. Among these have been global political stresses generating increased fears of protectionism, debt management crises, ecological disasters, rising geopolitical tensions and lack of vigour in some key advanced economies.
In this environment, investors have needed to be very sensitive and aware of risks, especially with the
experience of 2008 fresh in memory. Though many of these perils will always be present in some form, we have in the past couple of months seen a wave of amelioration in issues that are key for global economic growth. In our view, the risk of disruptive events in the year ahead is now significantly lower.
Among the improvements are the recent alignment of U.S. monetary and fiscal policy on economic stimulus,
a perception that the euro zone has the ability and political will to contain its debt problems at least in the
medium term, and key economic indicators supporting solid global prospects for 2011. We are pleased by
the stability of liquidity conditions in the interbank market in 2010, especially in periods of increased risk
of European debt default.
All this leads us to upgrade our view of equity markets for 2011. We recommend an increase in equity
exposure to slightly overweight from market weight. We have raised our equity allocation 4 percentage
points to 59% and reduced our cash position to 6% from 10%.
Within our equity universe we are raising our Canadian exposure 2 points to 32% (benchmark 30%), in line with our long commodity view for the next 12 months. We are also raising our position in U.S. equities to 12% from the benchmark 10% and in foreign equities (EAFE) to 7% from 6% (benchmark 10%). We are slightly reducing our overweighting in emerging markets, to 8% from 9% (benchmark 5%).
Sector rotation: Resources will shine
Our sector mix is unchanged this month. We continue to favour resource stocks. In our view, continuing
global expansion and solid growth in key emerging markets, combined with depreciation of the U.S.
dollar in trade-weighted terms, are likely to push commodity prices to new cyclical highs in 2011. As
the table below shows, the two resource sectors have been outperforming the composite index in the fourth
quarter, a trend that we expect will continue into the New Year.
The prospects for resource companies are also supported by earnings momentum. The Materials
sector has shown the largest 12-month earnings revisions over the past month (+2.3%) and the past
three months (+10.7%), a signal that this group has wind in its sails.
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