Further gains likely in equity markets

Sep 9 2009 by Andrew Miller, The Journal

EQUITY markets have started to run out of steam following their impressive gains since the March lows. Oddly, this is happening against a background of better-than-expected economic and corporate earnings data.

The event that seems to have triggered the setback in markets was the news from China that the authorities there are keen to start withdrawing support for the financial system by scaling back the availability of bank loans. As a result, the Chinese stock market indices slumped by over 20% in August, although they have recovered some of their losses in recent days.

The less-than-supportive news from China is the anomaly among a generally positive tone to the majority of economic data. Last week saw the release of more data in the form of activity surveys for the manufacturing sectors in the key developed economies. Broadly, these were stronger than markets had expected (with the notable exception of the UK, which was weaker than markets had anticipated). Furthermore, the service sector indices also confirmed the improving tone to economic data releases. In turn, these were complemented by the US non-farm payrolls report for August, which showed a decline of -216,000, again a better outcome than the one markets had been looking for.

The tone of corporate earnings has also been one of an improving trend and, perhaps more importantly, the better news emanating from the corporate sector is resulting in upgrades to earnings expectations. The latest estimates suggest that, globally, corporate earnings will fall by around 10% this year but will increase by 25% next year. Moreover, looking at earnings revisions (defined as upgrades to company estimates as a percentage of total grade changes), there has been a sharp rebound from a low of just 10% in January to over 60% now. Upward moves in these ratios tend to be supportive of equity markets. This suggests to us that the current consolidation phase in markets is unlikely to be sizeable or indeed prolonged. With this in mind, we would reiterate our view that investment portfolios should be fully up to their normal weightings in equity markets, as some investors may still be focused solely on the lowest-risk assets such as cash or short-dated Government bonds. In our view, equity market setbacks like the recent one should be used as an opportunity to close out any major underweight positions.

In terms of our equity sector recommendations, we have maintained a modest economically-sensitive or “cyclical” bias over recent months and this has generally served us well as markets have recovered. We still believe that equity markets are in recovery phase, and should be able to make further gains over the months ahead. During this phase of recovery, equity valuations should pose less of a concern to investors. This leaves us with little conviction to make any major shifts in our investment approach. We would note however that the materials sector is beginning to look somewhat expensive. Consequently, we are choosing to play any rebound in commodities markets via the energy sector (noting that the performance of the latter tends to move in step with that of materials) as it offers a better valuation.

Elsewhere, we continue to like industrials and IT, both of which give us cyclical exposure, and fund these overweight positions with modest underweight positions in the two most “defensive” sectors, consumer staples and utilities.

Andrew Miller is regional office head of Barclays Wealth