Optimistic outlook for equities

Apr 15 2009 by Andrew Miller, The Journal

EQUITY markets have staged an impressive rally since the recent lows in early March, with some of the major indices making gains in excess of 20%.

The rally has been led by those sectors that suffered the most in the sell-off, with economically-sensitive ‘cyclical’ sectors in particular delivering strong returns. At the moment, it is difficult to tell if this is a bear market rally or the start of something more sustainable. But what we do know is that there are now signs that the global recession should not evolve into a depression.

It is with this thought in mind that we are turning cautiously optimistic on the outlook for equities, which leads us to believe that exposure here should be focused on markets and sectors that will benefit from an economic recovery. Regionally, we expect that the countries that will lead the global economy out of recession will be the US and China, while Europe and Japan will lag. To our mind, given this likely path of recovery, the region that offers the best risk-adjusted returns is Asia (excluding Japan).

Asia ex-Japan (of which the largest stock markets are China, Korea, Taiwan, Hong Kong, and India) offers investors exposure to the region that is likely to see the strongest recovery in economic performance over the coming months. The fiscal packages announced in Asia over recent months (most notably in China) should fuel domestic demand growth. Furthermore, Asian ex-Japan equities offer good gearing to recovery as risk appetite increases.

Within all regional equity markets we would also look to increase cyclical exposure by tilting sector exposure more towards economically-sensitive industries and away from expensive ‘defensive’ sectors. Historically, cyclicals have delivered significant outperformance in the 12-36 months following the start of a recession, something we expect to see again in this cycle.

Up to now our sector recommendations have favoured a slight cyclical bias in anticipation of a recovery, especially as the defensive sectors – consumer staples and utilities – were trading at a significant premium. We have re-run our price momentum, earnings and valuation screens for all the major global sectors and the trends that we are beginning to see emerge are that cyclical sectors are benefiting from a general improvement. By contrast, the traditional defensive sectors have lagged, especially in terms of price and earnings momentum.

This brings us on to our sector calls. The overall theme of the recommendations is to be overweight sectors offering value and cyclical earnings exposure and underweight the ‘expensive defensives’. This leads us to favour positions in materials, industrials (where we expect the inventory cycle should help this sector over the coming quarters), consumer discretionary and information technology. However, we are not quite ‘out of the woods’ yet in terms of the economy, so we are also holding an overweight in telecoms, the only ‘cheap defensive’. Our underweight positions remain focused on consumer staples and utilities.

In the short term, the first-quarter US earnings season will give us more clues as to the direction of corporate earnings. The earnings season began with Alcoa releasing disappointing numbers and indeed earnings in aggregate are forecast to fall by over 35% year-on-year in the first quarter. Lots of attention will be focused on financials, but the real weakness is likely to come from the non-financial sectors, where we expect to see some significant disappointments. However, in contrast to the start of the year, the outlook for equities is at least no longer universally bleak.

Andrew Miller is regional office head of Barclays Wealth in Newcastle.