There is an unusually tight consensus for the developed world outlook this year, hinging on the likelihood that the G-3 economies are headed toward synchronized growth although recall that the consensus a year ago only expected a 10% return on US equities (rather than the 32% total return the S&P generated) and was oblivious to the looming gold collapse, surge in global tech valuations and EM deficit risks. The global economy is indeed seeing improved developed world momentum into Q1, based largely on corporate spending and the manufacturing sector as reflected in the December JPM global PMI – capex plays remain a preferred theme for structural as much as cyclical reasons, as covered in the recent ‘Internet of Things’ note. As expected, China’s credit and infrastructure led acceleration which peaked back in Q3 is now rolling over, while FX volatility remains high across GEM, driven as much recently by political risk (Turkey, Thailand – India as an AAP/Congress coalition looms?) as weak deficit and growth fundamentals.
A benign outlook has been broadly priced into global developed market equities (and particularly US) with the trailing PER ratio rising to 16.6x from 13.8x at the end of 2012, largely because of multiple expansion as the implied equity risk premium has reverted to historical norms (at just sub 5% in the US), which was the basis of my 1800 S&P target a year ago. On that analysis, US equities look fully valued and it’s notable that 94 S&P constituents have issued negative guidance for Q4 and only 13 positive. The most persistent and significant valuation anomalies globally lie in (highly correlated) emerging markets and materials, where the consensus is weakest but net bearish.
The biggest macro risks in 2014 stem from China’s $1.2trn local government refinancing amid persistently tight liquidity and the Fed losing control of the bond market, with accelerated growth reflected in a spike in 10-yr yields beyond 3.5% amid a surge in outflows. I’ve always been convinced that depressed Treasury yield levels were less a function of Fed QE than extreme investor risk aversion and that is true more or less globally (less in the case of Japan given the relative scale of BOJ activity). It’s remarkable that we haven’t seen a meaningful correction in US equities over the past 18mths, and now that the earnings yield gap has largely closed (versus BAA bonds) equities will become much more sensitive to bond market volatility. We are likely to see a sixth straight year of positive total returns for the S&P 500, but with a 10-15% pullback in H1.
A target of 1950, based on a 16x PER and projected 2015 EPS of $123 represents a return of just 7%, almost all of which represents earnings growth. An issue being widely overlooked is that US companies would in a faster growth environment finally have to divert cash flows from buybacks ($500bn last year) and dividend hikes to wages and capex and as covered in recent notes, buybacks have been a key support for US equities. Since the start of the current bull market in Q1 2009 through Q3 last year, share buybacks have totalled $1.6trn and dividends $1.2trn. Indeed, the $207bn total of US share buybacks plus dividends in Q3 was just shy of the $233bn record in Q3 2007 although corporate cash flow rose to a record annualized high of $2.3trn during Q3. About 84% of S&P earnings were paid out in dividends and buybacks in 2013. Overall, it’s crucial that the benefits of growth and ultra-loose monetary policy now switch from Wall Street to ‘Main Street’ to sustain S&P revenue growth via domestic aggregate demand as EM growth falters and signs of that process starting are worth watching in coming months in the employment and investment data.