Investment’s autumnal phase

- KBC Asset Management*


In this phase, corporate investment should begin to take the lead, the labour market has tightened and growing cost pressure is pushing up inflation forecasts, raising pressure on interest rates and depressing profit margins. Equity market valuations can tend to rise late in the cycle, too. As the investment clock moves on, we will switch from a profit-driven to a valuation-driven equity market.

Uncertainty and the resultant share price volatility are typical of a transitional period like this. The 26 February to 14 March mini-crash illustrates how sensitive the financial markets have become to economic doubts.

US: Although consumer spending continues to grow strongly, there are downside risks. Gasoline prices have risen by over 40% since February, taking them back to the record levels of August 2005. Consumer confidence in car-oriented America is extremely sensitive to developments like this. Falling house prices and tighter credit are also crucial. The recession in the housing market, which seemed a few months ago to be bottoming out, is now back with a vengeance.

However, these risks can be avoided if buoyant economic activity continues to create enough jobs. Job creation has weakened a little recently, but employment is still growing at 1–1.5% year-on-year. With accelerating pay rises (roughly 1.5% above inflation), household purchasing power could rise 3% (annualised) in the quarters ahead, creating a solid base for further economic expansion. At the same time, all conditions are there for corporate investment to start playing a more dominant role. Profits are peaking, cash positions are substantial, the labour market is tight and producer confidence is high. As yet, however, there are no tangible indications that investment is indeed picking up.

EMU growth is currently at its most robust for ten years, with consumer spending, investment and exports all on the way up. The signs are that the European economy has finally managed to uncouple itself from that of the US. All the same, we ought to allow for a certain lag, if only because exports will inevitably begin to experience the negative consequences of the expensive euro.

China: Growth appears to be accelerating again but whether the rate is +10.5% or +11.5%, it is straightforwardly ‘high’. Successive attempts at monetary tightening and credit restrictions support that reading and are proof that the Chinese government also considers growth to be on the high side. The ‘China’ factor is one reason why the world economy continues to grow at over 4%.

Against this backdrop, the late-cyclical phenomenon of accelerating inflation is threatening to move back centre stage, especially if doubts about the economy subside and the second-stage pattern becomes increasingly clear. High oil and commodity prices have an important part to play. One of the lessons learnt in the past few months is that a serious slowdown in US growth need not have any impact on commodity prices. Since the Asian economy has detached itself from its US counterpart, global demand has remained robust. In the meantime, unutilised capacity is still limited, as there has yet to be any genuine wave of investment in expansion. Should growth in the US pick up again in the months ahead and if the economies in Europe and Asia continue to be buoyant, unremitting upward pressure on commodity prices could become a real worry in the short term. Accelerating pay rises are another factor. Labour markets have tightened almost throughout the West.

Central bankers will remain wary. The Fed and especially the ECB continue to stress inflationary risks making any interest-rate cuts in the near future unlikely. In the US, if action has to be taken, we believe rates are more likely to be hiked than cut, at least until the beginning of 2008. Our forecasts, therefore, depart from the market consensus. Bond prices suggest that the market continues to place a 50% probability on a cut of 25 basis points in interest rates by the end of 2007.

The ECB has the economic wind in its sails and could hike rates several more times yet. A further increase in interest rates (to 4.25% in September and to 4.50% in December) is all but certain. Possibly a third hike could then occur in the first half of 2008. The market is discounting to a great extent these actions.
US bond yields are creeping up. The expectation of interest-rate cuts has yet to fade as an influence on US bond prices and anticipation of higher rates will then gradually have to feed in. European bond yields do not only follow those in the US, higher rates can also be fuelled organically by internal European factors. Europe’s domestic economy is stronger than that in the US, for instance, and monetary policy is plainly undergoing a period of tightening.

With world GDP growth of 4–4.5%, inflation at around 2.5% and constant margins, the earnings mass could rise 6.5–7% in the next 12 months. Those profits will be spread over 2.5% fewer shares (due to sizeable share buy-back programmes and mergers), with the result that earnings per share could go on rising at 9–9.5%. While that might entail a slowdown in earnings growth, it remains a fine prospect for the second phase of the cycle. What’s more, this kind of macro approach actually tends to underestimate performance. For various reasons, listed companies are generally more efficient than unlisted ones. Either way, there is still more scope for pleasant surprises than for disappointments. More important, however, is the knowledge that forecast earnings growth is substantially higher than bond yields and that this growth will have to feed through in due course into equity prices.

Equities are cheap compared to expensive bonds. In this cycle, the massive increase in earnings has not been accompanied by a similar increase in share prices and valuation yardsticks, such as the price/earnings ratio, have not gone up. Therefore, equities remain undervalued. There are few alternatives. Even defensive investors end up opting for shares now that the potential for an extra yield in the fixed income market is limited (little scope for interest-rate cuts, inadequate compensation for the credit risk), real estate has become very expensive and the surge on the commodities markets appears to have passed its peak.

*KBC has a 51% stake in Liontamer.

Liontamer’s latest capital-protected issue Global Series 3, has exposure to international share markets.