Markets face a number of risks with binary outcomes, not least the imminent fiscal cliff facing the US economy.
While the prospects for earnings growth in most developed equity markets are now more modest, a positive case can be made for a re-rating of equities, yet this is dependent on progress being made against some powerful headwinds.
The positive case for equities rests on three supportive factors:
- Equity valuations are reasonable relative to history, with price/earnings (PE) ratios of around 13 to 14 times trailing 12-month earnings. While this is not extremely low, the relative attractions of equities are enhanced when valuations are compared with sovereign and investment grade bonds.
- We have seen sustained outflows from equities in the last few years, so much so that institutional levels of equity ownership are now at 30-year lows. Equities are an unloved asset class and there is growing scope for a reversal of this trend.
- Volatility has subsided. I have always believed a reduction in volatility is a prerequisite to any re-rating in equities. Encouragingly, the VIX has fallen back to around 15 per cent, having remained below 20 per cent since July.
While these factors make a re-rating possible, there are some considerable hurdles to be overcome that could prevent it. In my view, there are three key risks facing equity markets in 2013:
- Lack of a resolution to the US fiscal cliff would throw the US and global economies into recession. The likelihood of going over the cliff, and detracting around 4 per cent from GDP, is being underestimated given the ideological divide in Congress.
- The economic, sovereign and banking crisis in Europe remains unresolved despite central bank promises having had a favourable impact. With politics in peripheral countries becoming radicalised, there is the potential for more flare-ups. Unfavourable debt dynamics and poor economic fundamentals suggest further deterioration is likely.
- Geopolitics, particularly in the Middle East, could pose a significant and unpredictable risk in 2013, this being the year that the confrontation between Israel and Iran over nuclear facilities is likely to come to a head.
In this respect, equity income remains an attractive story given the dividend yields available on equities compared with government bonds.
In Europe, investors can expect yields of around 3 to 4 per cent, except in financials where many dividends have been scrapped.
Balance sheets are healthy, cash-flow is solid and payout ratios are low with scope to grow.
I think we will see earnings and dividend growth of 4 to 5 per cent in 2013, particularly at large high-quality companies.
So, if you combine 3 to 4 per cent dividends and estimated growth of 4 to 5 per cent, we can generate attractive total returns of 7 to 8 per cent, which should support further flows into equity income funds.
In terms of sectors, I expect the leadership we have seen over the last year to continue. Quality will remain a powerful theme and stocks with high returns on invested capital will continue to attract a premium.
I think selected healthcare, technology and consumer stocks remain attractive. There are high-quality stocks available with strong franchises benefiting from structural tailwinds; many of these are also returning cash to shareholders, such as Nestlé, Unilever, and Sanofi.
With these strong multinational companies, investors can be fairly confident that they will get their money back and in the meantime, they receive a higher income than they would from investing in sovereign bonds.
Some pharmaceutical companies are on single-digit PE ratios despite having among the highest returns on capital.
Among technology companies too, there is good scope for dividend growth: some of the large technology stocks have matured into stable, lower-growth businesses that offer attractive total returns.
While the estimated 3.5 per cent yield on Microsoft may seem a little low, this is covered about four times by cash. This means that it has the potential to grow dividends in the future significantly ahead of earnings.
Regionally, emerging markets are relatively attractive given their better growth rates and the fact that capital is likely to flow to investments in higher-yielding currencies.
Indeed, I expect currency appreciation to be a growing theme in the emerging world given the synchronised balance-sheet expansion at developed-economy central banks.
The Chinese economy is well placed to have a rebound in 2013; inflation has been brought under control and the leadership transition is now out of the way, suggesting policy can be accommodative.
Investors appear to have discounted economic growth rates in the 6 to 8 per cent range and the market should perform relatively better now that these headwinds have passed.
In developed markets, the US looks attractive if the fiscal cliff can be successfully navigated. The housing market is recovering, which is a key bellwether for the broader economy, and consumer confidence is also picking up.
In energy, the US could become the largest producer of both gas and oil thanks to the exploitation of its shale reserves. But it is the broader effect of cheap energy costs on the economy that is particularly supportive; this will give the US a competitive advantage among advanced economies and play a central role in the renaissance of US manufacturing.
A wide range of industrial sectors from chemicals to engineering are expected to benefit from significantly lower input prices.
Dominic Rossi is chief investment officer for equities at Fidelity. The views expressed here are his own.