Real value to be found in the equity markets

The uncertainty over the health of the Chinese economy and US rate policy, not to mention the tensions surrounding Volkswagen, have placed the equity markets under severe pressure. Thanks to this correction, there is now real value in the equity markets.

In recent months, the equity markets have undergone a severe correction. The summer, nevertheless, had got off to a good start after Greek premier Tsipras and the Eurozone had, unexpectedly, come to an agreement, one which averted a possible exit of Greece from the Eurozone. The relief was, however, short-lived. In August, the Chinese equity market suffered its steepest fall in eight years, after disappointing economic figures disclosed to investors a Chinese economy in ill health. The decision taken by the Chinese authorities to make the yuan more flexible was the last straw, and led to the forfeiture of almost all gains. September was another tough month. The US central bank kept its rate unchanged while remaining relatively cautious in its communications. This cautious approach, however, only served to create uncertainty about the global economic context, which, in combination with the vicissitudes of Volkswagen, put pressure on the equity markets. The equity-market correction of 10% since early August has been a source of opportunity. What follows is an overview of the actual impact of the risks that have arisen in recent months and a number of reasons why we are convinced that equities are currently a worthwhile investment target.

Growth of the developed economies

The economic context is still equity-friendly. In the United States, the ISM indices, which update us on economic-activity changes, are still topping 50, the level that distinguishes growth from contraction. The low oil price is slightly supportive of consumption, as is the strong increase in US household’s purchasing power. The sole factor to somewhat impinge upon US economic growth is the impact of the relatively expensive dollar on export growth.

In the meantime, the recovery is spreading throughout the Eurozone, i.e., both in the core and in the peripheral countries, with Spain out in front. In addition, the economic sentiment index is pointing to an expected growth figure of around 2% (annualised). In the Eurozone, too, households are already benefiting from the lower oil price and an improving job market. This could make consumption the driver of the economic recovery. Against such a background, economic growth would have to amount to around 1.5% for the whole of 2015 in order to accelerate to almost 2% next year.

Rather limited impact of the Chinese growth slowdown

In the emerging economies, economic momentum is currently weaker; that includes China, which, in recent months, has dominated the markets. In truth, however, economic growth has significantly slowed down these past few years in China. Before the Great Recession of 2008-2009, Chinese economic growth amounted to 14% annualised. Although this figure has halved, it is still comparatively higher than growth in the developed economies and not completely unexpected. The Chinese government deliberately went about reforming its economy in order to adopt a sustainable growth rhythm that would help the country switch from being an industry- and investment-driven economy to being a service economy driven more by domestic consumption. The switch will continue to weigh on growth over the next few years, even though a hard landing could be avoided courtesy of the measures taken by the Chinese government. We’re estimating annualised growth of around 6%.

The low growth is, of course, affecting the global economy, even though it is rather limited in the developed countries. The percentage of total exports to China is, both in the US and in the Eurozone, limited to around 6% (see diagram). In addition, the IMF has calculated that an accumulated growth slowdown of 1% in China would have only a 0.10% impact on US growth and a 0.15% impact on Eurozone growth.

 
Sources : Datastream, Candriam

Liquidity still supportive

In the meantime, the global central banks are still flexible. Even though the US central bank is no longer providing extra liquidity, both the European Central Bank and the Bank of Japan are still buying assets. Accordingly, the combined balance sheet of the world’s biggest central banks (Japan, Europe and the US) continues to grow, supporting the equity markets along the way (see diagram: central bank balance sheet versus the MSCI World balance sheet). It is, moreover, not just the developed-country central banks that have a flexible monetary policy. In the emerging countries, too, monetary policy is fully focused on stimulating economic growth.

 
Sources : Bloomberg, Candriam

Corporate profits riding the wave of economic growth

The economic recovery has, in the meantime, also started to seep into corporate profits. Although it is as yet too early to judge the only-recently-commenced Q3 results season, Q2 publications had already confirmed the positive trend, especially in Europe, where almost 70% of companies in the Stoxx Europe 600 600 published higher-than-expected profits. In addition, Q2 profit growth was, YoY, more than 10% up (source: Factset). This trend should continue, leading to profit growth in the Eurozone topping 10% for the whole of 2015 and 2016.

Valuation again attractive

The equity markets were, until just before the summer, in absolute terms, no longer cheap, especially in the United States. Currently, however, valuations have become more attractive. In the Eurozone, the forecast P/E for the next 12 months is still somewhat lower than the long-term median has been since 1991. The US and the UK are both relatively more expensively priced than at any time in the past.

The emerging countries are currently the most difficult to estimate. Although the forecast P/E for the next twelve months is more attractive than the long-term median (1991-today), if we factor the lower growth expectations into the valuation process, it becomes less so. The forecast P/E for the emerging countries, which is currently positive in Asia only, is putting the region at a further disadvantage.

All told, therefore, Eurozone equities are especially attractive.

Impact of rate increase should remain limited

In the meantime, a close eye will be kept on the Fed. Although Chair Yellen did not raise the rate in September because of the uncertainty in, amongst other places, China, she is likely to do so by the end of 2015. The market is betting on an increase of 0.25%; the right call, in our view. Economic growth is flourishing, the job market continues to improve and core inflation, without energy and nutrition, is at almost 2%. Any rate increase would, in the first instance, place the bond market under pressure, and could also impact the equity markets. From a historical point of view, this could average 9%. We then, however, take it that things will be different this time. The rate increase will, unlike in the past, be carefully and gradually implemented. Also, the other central banks are staying flexible, meaning that the impact on European equities should remain limited and, last but not least, we have already experienced a solid correction, whose impact will possibly be less pronounced.

Conclusion: equities still attractive

The current context of economic growth and increasing liquidity is highly supportive to the equity markets. In the meantime, the forthcoming US rate hike will probably impact the bond markets, where the current rate is at an all-time low. Increasing corporate profits and a valuation that has again become more attractive (especially in the Eurozone) will also bolster equity-market performance in the coming months.

Volkswagen unimportant to the big picture

Volkswagen’s emissions fraud shocked the market. Once the results of the investigation were published in the United States, the share took a major hit. We briefly outline the impact of the scandal on Volkswagen.

Volkswagen’s turnover in 2014 amounted to €200 billion (give or take). Around 9% of sales are recorded in the US, where, now, more than 20% of sales have been recalled. That accounts for around 2% of total T/O. The company, with its annual upwards-of-€10-billion of T/O, has already set aside a provision of 6.5 billion, a figure that will be insufficient to offset the eventual costs, fines and reputation risks. We can, nonetheless, say that, regardless of how big Volkswagen is, the impact on the global industrial sector remains limited. In 2014, Volkswagen accounted for around 2.5% of global industrial investment, proof of the limited impact the Volkswagen story will have on the world economy.

Ken Van Weyenberg
Investment Specialist - Asset Allocation & Private Clients