End of equities trough is nigh

Aug 12 2009 Andrew Miller, Regional office head of Barclays Wealth

EQUITY markets broke into new highs for the year last week. The recent strong gains in markets have been led by a much stronger-than- expected second-quarter earnings season in the US.

With more than 80% of the S&P 500 having reported, earnings have been about 5% higher than expected at the start of July, which leaves year-on-year earnings down by a little shy of 30% for the second quarter.

This outcome is prompting analysts to revise earnings estimates. Indeed, we appear to have seen – or are approaching – the bottom in terms of earnings downgrades.

And current forecasts are for a strong rebound in earnings growth for next year, leaving equity markets on fairly reasonable forward price-to-earnings multiples.

The broadly positive tone to the economic news flow has also helped sentiment towards risk assets.

At the start of the month, Institute of Supply Management indices in the US and their sister purchasing managers’ indices in other countries have provided pleasant surprises across the globe. This indicates that the third quarter should continue the improving trends seen in the second quarter, following a first quarter much worse than expected for GDP.

Looking at the bigger picture however, the pace of recovery in the past couple of weeks has slowed and consequently we expect equity markets will be fairly choppy over the rest of the summer.

Regionally, some markets, such as Asia, are beginning to look expensive after a period of very strong performance and we advocate a more selective approach in areas where valuations have risen sharply of late, while recognising that Asia is likely to remain the most economically dynamic region.

Taking a longer-term perspective, and even after the near 50% rally in equity markets since the lows seen last March, equities still look well placed to make further gains over the coming quarters, in our view.

It is still hard to argue that equities look expensive when compared with long-run historical valuations.

As the economy recovers, and earnings return to growth, equities are at a good starting point from which to make sustainable gains – a contrast to 2003, for example.

At a sector level, the modest economically-sensitive bias of our sector calls has performed well in the past month, as lower-risk “defensives” have lagged.

With markets clearly in recovery mode and valuations posing less of a concern to investors, we reiterate our view that now is not the time to implement aggressive sector calls or major changes in investment style.

Nonetheless, we are making a couple of tweaks to our sector calls this month. The materials sector is beginning to look expensive and its positive earnings momentum is tailing off, so we are now neutral in all regions except the UK.

In order to maintain exposure to commodities (which should benefit from Asian economic growth) we have upgraded the energy sector to moderate outperform.

We continue to like industrials and IT, both of which give us cyclical exposure, but we are downgrading the telecoms sector to neutral.

The sector’s attractive valuation is no longer grounds for an outperform recommendation following the sharp fall in price and earnings momentum.

Our cyclical sector bias continues to be funded by modest underweight positions in the two most “defensive” sectors – consumer staples and utilities.