Does the Global Bull Market Have Room to Run?

While there have been pockets of volatility interrupting momentum along the way – such as the March/April pullback – global equities have been climbing higher for several years now. In fact, the S&P 500® recorded its fifth straight quarterly gain while the MSCI World Index reached new heights in Q1 and surpassed its pre-recession peak.

Four equity experts from across Natixis Global Asset Management provide insight on current fundamentals of U.S., European and global equities, signposts for an expansion or contraction and where they are identifying opportunities.

Richard D. Skaggs
Senior Equity Strategist
Loomis Sayles & Company

Skaggs points out that U.S. and major European equity markets have hovered around the unchanged line for much of 2014, trading in a fairly narrow range. Considering the fact that the S&P 500 returned over 32% in 2013, and over 10% in the fourth quarter alone, the recent period of consolidation is hardly surprising to Skaggs.

"Investors have wrestled with a number of macro concerns including emerging market equity underperformance at the beginning of the year, followed by a healthy rally in February, and have again faced headwinds since early March," said Skaggs.

On the plus side, the S&P 500 touched record high levels on several occasions in 2014, and Skaggs thinks the medium-term outlook remains positive – just not as positive as we experienced in 2013. Also supportive are signs that Europe is on pace for somewhat stronger economic growth. The decline in interest rates in many of the peripheral nations, he believes, has been supportive as well.

Signs supporting market expansion
While we have experienced a pause recently, Skaggs believes there are several important fundamentals supporting this bull market that in his estimation remain fully intact. "First, and perhaps most importantly, we expect the average earnings of companies in the S&P 500 to continue on a mid- to high-single-digit growth path this year," said Skaggs.

Second, while revenue growth has been sluggish, Skaggs sees signs that the U.S. economy may be starting to pick up steam following somewhat sluggish performance in recent months (in part due to the severe winter weather in North America). "U.S. employment growth has continued at a steady pace. Interest rates remain very low, supporting housing and automotive sales and permitting companies to continue to strengthen financial positions," he said. And while the Federal Reserve commands much attention, the continued tapering of quantitative easing is built into Skaggs' outlook.

Skaggs' list of positives is pretty long. He points out that the dividend yield on the S&P 500 has remained around the 2.0% level (even as the index has moved higher) as U.S. companies continue to raise payouts at a healthy rate. Share repurchases continue to be robust in addition to the strong pace of dividend growth in 2014. Inflation remains quite low, making the real return from owning equities attractive. Consumer confidence has trended higher, not just in the U.S. but worldwide. Also, equity fund flows have become more consistently positive since the beginning of 2013, following a long stretch of net outflows as investors flocked to bonds for relative safety.

Valuations remain reasonable
Reflecting this positive backdrop, price/earnings ratios have expanded in the past few quarters. In Skaggs' view, valuation remains reasonable for the S&P 500 overall. "An acceleration of Gross Domestic Product (GDP) growth would be welcome to give cyclical companies a stronger earnings tailwind. However, an acceleration is likely not required from current levels for earnings growth to continue around its current pace," said Skaggs.

Signs of a steeper correction
While it is possible for price/earnings multiples to expand from here, Skaggs' view is that if valuations continue to expand without underlying acceleration in operating earnings, the risk of a more significant correction could come to pass later this year.

"In recent weeks, many very richly valued technology and biotechnology companies have given back gains of the past few months. Also, many recent initial public offerings have struggled to maintain lofty valuations and have begun to correct. This is another signal that some portions of the U.S. equity market require something of a breather," said Skaggs.

Many of the stocks which have been more volatile recently are not part of the S&P 500, making this large-cap benchmark index several steps removed from recent volatility. While a correction of 10% or more in the S&P 500 is overdue in terms of time, Skaggs thinks the likelihood of that happening is more dependent on upcoming earnings reports and potentially unexpected macro developments than overall valuation levels.

Chris Wallis

President, CEO
Vaughan Nelson Investment Management

Despite the U.S. economy's slowest period of expansion since WWII, geopolitical unrest and impending interest rate increases, the S&P 500 has continued to push forward. While signs of economic growth are encouraging enough to support 2014 stock prices, Wallis believes it is the credit market that supports the equity market – and credit is booming.

"The belief that the equity market is moving up because the Fed is artificially keeping rates low is faulted. Stocks are progressing because credit funds are buying debt and the money is being used for corporate buybacks. This leads to an increase in earnings per share and buoys stock prices," said Wallis.

Why is this happening? Wallis believes several years of low interest rates have led to a substantial difference between the returns pensions typically require to meet their objectives and what credit has offered in this low-rate environment. As a result, pensions have been buying into leveraged credit funds – adding cash on to balance sheets of corporations. This cash is then used by companies for capital expenditures and stock repurchases, also known as corporate buybacks. "These stock repurchases are acting as a foundation to support the stock price levels we are witnessing today," said Wallis. Eventually, he believes pensions could run out of capital, and when that happens, leveraged credit funds will be unable to meet their margin calls and the potential for the credit boom to bust will be greater.

More opportunity in mid-caps
From an investment perspective, Wallis is identifying the most attractive opportunities in the mid-cap (stock of medium-sized companies) space. "Mid-caps are attractive relative to small-caps because of scale, stronger balance sheets, greater access to capital markets and wider international reach. This allows them to better endure economic shocks as compared to small-caps," said Wallis.

Compared to large-caps, mid-caps typically have higher earnings growth. They also tend to benefit on both sides of mergers and acquisitions. "Mid-caps are big enough to make sizable acquisitions, but are of a size where they are still attractive acquisition targets," said Wallis. Additionally, he believes mid-caps have many of the appealing functional characteristics of large-caps while operating within a capitalization where inefficiencies are frequent and identifiable.

In summary, Wallis believes we are in the midst of another credit boom. "We are positive on the market over the medium term, but 2013's gains need to be consolidated over the short term. This market magnifies the importance of security selection for investors moving forward," said Wallis.

Yves Maillot

Head of European Equities
Natixis Asset Management

 

One market underpinning Maillot believes could continue to help the forward momentum of developed European stock markets in 2014 is accommodative monetary policy of central banks. "G20 countries recently declared that monetary policies should stay accommodative for now in many advanced economies and pledged a coordinated push to boost growth. This means that financial markets are still driven by excess liquidity, even if the Fed tapering cuts monthly bond purchases to $55 billion," said Maillot.

Maillot warns, however, that global equity markets began 2014 expecting better things from the global economy and from corporate earnings growth too. But the picture has been more uncertain. "Even if profits are high and S&P 500 earnings growth is quite good in the U.S., valuations have reached high levels (2013 price to earnings ratio (P/E) of 17.5). In Europe, multiples are much lower (2013 P/E of 16 and 14.5 for the U.K. with better economic conditions) but earnings growth has been disappointing for many years and consensus forecasts have been consistently over-optimistic," said Maillot.

Maillot views the global macro picture as quite mixed. "The growth trend is clearly better, but expectations are now under pressure as Europe's nascent economic recovery has apparently run out of steam, Japan's underlying economic data remains lackluster, growth within the emerging markets appears stalled and even the U.S. has begun to produce some less convincing data," said Maillot. Despite an economic recovery, and as the stock markets produced double-digit performances over the last 12 months, he points out that equities have already priced in much of the positive economic news.

Opportunity in small- and mid-cap European stocks
In Europe, Maillot says he continues to find more opportunities in small- and mid-caps versus stock of large companies. "Within the STOXX® Europe 600 Index, two-thirds of the components are small and mid-sized companies but represent only 20% of the total market capitalization. The average valuations of small- and mid-size listed companies are slightly higher than those for large-caps, but the estimated growth is larger and gives room for a further expansion," he said.

For large-caps, the cash return is an important theme throughout 2014 as corporations' cash balances are very large and offer more potential for mergers & acquisitions and dividend distribution. Looking for high and regular dividend yields, some names are interesting in the telecom sector and in the integrated oil sector due to slowing capital expenditure growth potentially allowing greater free cash flows and dividends payment. Also, Maillot continues to find pharmaceuticals interesting because of visibility, and the automotive sector for its profit momentum. He thinks some banking names still possess potential for valuation expansion.

Headwinds for European equities
Maillot believes the biggest challenge facing equities in Europe is a possible economic growth disappointment and lower profit growth than expected. "As inflation slips ever lower, a slide into deflation looks possible and this would challenge profits in Europe," he said.

Maillot believes geopolitical risks remain in the region as well. "If we have learned anything over the last few months, it is that the Russia-Ukraine situation is so fast-moving that it would be hard to predict coming events and their consequences. Up until now, the markets stayed quiet, but it could change at any time," said Maillot.

Robert Taylor

Director of International Research, Portfolio Manager
Harris Associates

 

After years of market expansion, the value investor Taylor says he is still identifying plenty of attractively priced opportunities in global equities. "As we move into Q2, there is still value in global equity markets. Certainly stocks are not selling at the incredible bargains they were in early 2009 or even early 2012, but with global economic growth appearing to be poised to accelerate, and with stock valuations that are still attractive, I believe there are reasons to be confident that global equities will likely continue to be an attractive asset class," said Taylor. 

With global gross domestic product (GDP) growing around 3%, strong profitability among many companies and cash on corporate balance sheets at some of the highest levels he has ever seen, Taylor says the backdrop is attractive to invest in quality, globally diversified businesses. 

Finding value in European companies
There are numerous reasons to invest in Europe at this time, according to Taylor. "The International Monetary Fund predicts global growth above 3% in 2014, which provides an environment where European companies can operate profitably. Firms such as Diageo and Nestle generate 45% of their operating income from regions that fuel this predicted global growth, specifically emerging markets," said Taylor. He also points out that luxury auto makers like Daimler and BMW potentially have a dual path to growth – the premium auto sector is structurally taking share within the overall sector, and they have significant opportunities to grow in emerging markets. Of course, Taylor's views on companies should not be considered a recommendation to buy or sell any stock. 

Taylor also points out that multiple other European companies, including a few European banks, have taken advantage of the recession to clean up their balance sheets, cut costs, trim capital expenditures and hoard cash. 

Pockets of value in Japan
Over the past several years, Japan has become a frequent travel destination for Taylor and his fellow global bargain-hunting equity managers David Herro and Eric Liu. "We recently spent a combined four weeks in Japan visiting companies," said Taylor. 

Taylor is pleased to see that Japan seems to be making progress at addressing its structural shortcomings. "Corporate Japan is somewhat behind the world in corporate governance standards and profitability. But change is happening. For example, Olympus now has, in our view, an extremely strong Board of Directors with a significant number of independent, outside directors. Additionally, the management has stated that their key objectives are to increase operational returns and position the company to resume cash returns to shareholders," said Taylor. In addition, Japan's new Liberal Democratic Party government is helping by trying to push corporate reform. "Also, from an economic perspective, the weaker yen resulting from a looser monetary policy has not only helped corporate profitability, but has greatly improved sentiment," said Taylor.