Room for more upside from equities?

4th February 2013

Dan Morris, Global Strategist at J.P. Morgan Asset Management says that despite big gains for equities, it is still the asset class to be in.

Room for more

Equities are up 5.7 per cent year-to-date; the gain since the 9 March 2009 is over 100 per cent (21 per cent annualised, total return in local currency for MSCI ACWI). Is it too late to be adding equity exposure? Clearly it would have been better much earlier, but anxiety about the eurozone crisis kept many investors in safe, if less profitable, assets. In 2012, around $50 billion was redeemed from equity funds following $175 billion pulled in 2011. Sentiment has now changed, however. Net new cash flow into equity funds picked up sharply again this week at the expense of treasury, investment grade corporate bond, and money market funds.

Several factors still favour equities and the performance relative to fixed income should continue to be positive. The most important consideration for longer term returns is valuations. Figure 1 shows valuations for both equities (based on the S&P 500 forward P/E) and for fixed income (using the expected real yield for US 10-year Treasuries). Equity valuations have increased over the last year but remain “good value” compared to the average PE since 1985. Real yields for Treasuries are around 0 per cent compared to a pre-crisis average of nearer 3 per cent, however, so fixed income still looks to be poor value.

Figure 1: Relative asset valuations*

Last data 1 February 2013. *Bond valuation based on US Treasury 10-year yield less expected core CPI inflation. Equities based on forward PE for S&P 500.  Stochastic scales values from 0 to 100. “Good” value defined as stochastic less than 25, and “poor” value as stochastic greater than 75. Source: Standard & Poors, IBES, Oxford Economics, Bloomberg, J.P. Morgan Asset Management.

If these categorisations did not correspond with future out- or underperformance they would be of no use. We can see in Table 1, though, that both asset classes had far better future one-year returns when in the “good” value region than when in either the average or poor value categories.  We do not anticipate equities will manage a 16.5% gain this year, but the gap between equity and fixed income returns could reach double digits.

Table 1: Future returns by valuation bucket

Valuation Bonds Equities
Good 11.6% 16.5%
Average 6.5 11.2
Poor 2.5 -5.1

Last data 1 February 2013. Note: Average of forward one-year total returns based on monthly value of stochastic. Source: Barclays, Standard & Poors, J.P. Morgan Asset Management.

In addition to sentiment currently favouring equities, central bank liquidity will remain abundant. The weakest support is earnings, which are growing but are not matching the same rates as in previous quarters (hence our more modest expectations for equity returns this year). About half of the S&P 500 has reported so far and companies have beaten expectations by 3% (excluding financials) but the increase in aggregate earnings versus last year is just 4% (again excluding financials). This rate should improve over 2013, but it will nonetheless be challenging for corporations to dramatically increase profitability as long as global economic growth and trade remain subdued.

US employment growth

Better than expected payrolls out of the US boosted markets on Friday, but the increase in the unemployment rate reinforced the mistaken perception that the recovery since 2008 has produced disappointing gains in jobs. The reaso
n the unemployment rate in the US is still high is simply because so many jobs were lost during the recession. Figure 2 illustrates that payrolls fell by nearly 8 per cent compared to a drop of just 3 per cent in the 2001 recession and far more than was seen in what had previously been the worst post-war recession, 1957.

Since the end of the 2008 recession, however, the US economy has been creating jobs at a faster rate than has been the norm during recoveries. During both the 1990 and 2001 recessions, payrolls expanded at just 0.7 per cent per year while it has been 1.1 per cent during this recovery. Even at that pace, however, it will take perhaps another two years before the economy returns to where it was in 2008. That means the Federal Reserve will be doing all it can to support the economy as it waits for the unemployment rate to fall.

Figure 2: US employment during recessions*

*Note: US Non-Farm Private Payrolls indexed to 100 at beginning of each recession. †Annualised growth rate of payrolls. Latest data January 2013. Source: BEA, J.P. Morgan Asset Management.


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