The global portfolio stance all year has been long DM versus GEM equities on relative GDP and earnings growth momentum, but there will be a negative feedback from the current EM turmoil on S&P earnings with Indian and Brazilian growth rates having halved since 2011. The import purchasing power of about 40% of the emerging economies has declined by 10-20% in USD terms in recent months, and while the pick-up in Europe will help, the earnings headwind is clear and geographical revenue exposure should certainly inform stock selection in coming months. Almost all S&P 500 companies have now reported Q2 earnings and while 72% have reported earnings above estimates, only 53% have reported sales above estimates, well below the average of 58% recorded over the past four years.
The blended earnings growth rate for the S&P 500 for Q2 2013 is 2.1% but the surge in financials sector earnings (28% y/y) flatters the aggregate data. The blended revenue growth rate for the index for Q2 is 1.7%. In terms of preannouncements, 85 companies have issued negative EPS guidance for Q3, while 19 companies have issued positive EPS guidance. As covered below, while rental versus mortgage costs are supportive, the housing market is showing signs of slowing after a 120bps spike in mortgage rates since May; the 25% slump in house builder stocks from recent highs is telling.
So are US stocks expensive or fairly valued on long-term valuation metrics? Value, like beauty, is in the eye of the beholder and the debate rages as to which metric to use from the 10-year cyclically adjusted real price earnings ratio (CAPE) to Tobin’s q (market valuation versus replacement cost, currently historically stretched above 1x for US stocks). Like most LT valuation measures, CAPE isn’t often useful for 3-6 month tactical allocation and emerging market investors have tended to dismiss it, since local GDP trend growth (and thus in principle EPS) has been on an accelerating LT path over the past decade. The ‘shock’ slowdown in aggregate emerging economy GDP and earnings growth over the past couple of years should serve to shake that complacency and if we rewound back to April, when I advised avoiding India and ASEAN markets, the CAPE calculation below showed Europe offering the most attractive LT expected returns and markets like Indonesia clearly overvalued. Of course, the financial sector distorts the 10-year earnings analysis for developed economies given that peak pre-crisis sector profitability won’t be achieved again in the foreseeable future, particularly in Europe, but the allocation signal remains strong.
I was making the bearish ASEAN/India call on macro risks based on clearly deteriorating external balances as much as valuations, but this approach looks useful for GEM as a ‘reality check’. The MSCI Indonesia Index has declined by 34% in USD terms from its May high, while the MSCI Malaysia Index has fallen by 16%. Stretched starting valuations colliding with very predictable macro volatility created a bloodbath for careless investors. ASEAN still doesn’t look bargain basement. Indonesia is on a 12-mth forward PER of 12x and Malaysia on 14.3x; GDP growth will slow in both, and is probably headed sub 5% in Indonesia while ROE is falling across the region. Operating profit margins in Indonesia at 18-20% are one source of comfort but Thailand (10.6x) alongside the Philippines look the most attractive bottom fishing opportunities for those brave enough to move underweight amid the consensus euphoria back in Q1. I’d retain an overweight on China (8.5x) and Korea (8.2x) given their late cyclical global exposure and FX resilience.