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Equity Insights Quarterly
A calmer third year
With double-digit earnings growth and no more PE derating,
we expect the global equities index to rise 11% this year
A more stable economic environment suggests stockpicking
and investment themes will matter more than macro factors
We stick to our preference for emerging markets
The global bull market that began in March 2009 is approaching its second anniversary.
We see nothing on the horizon to stop it yet. We think global earnings growth this year is
likely to be close to the consensus forecast of 15%. Valuations are cheap: the forward PE
for global equities is 12.3x, whereas at the start of the third year of previous bull markets
it averaged 18x. HSBC’s economists forecast 4.3% GDP growth for this year and next,
well above the 30-year average of 3.3%.
All this suggests 2011 will be a more stable year, in which earnings and economic growth
are steady but not particularly surprising. Global structural problems won’t go away; but,
as time goes on, they will lose their ability to shock. If earnings growth comes in close to
the current consensus forecast and multiples stay flat or even rerate a little, global equities
should be able to produce decent double-digit returns. We target an 11% rise in the global
index during 2011.
This background suggests a decline in correlations, with performance driven less by macro
factors than by calls on individual companies and by investment themes. We identify five
themes – pricing anomalies, low rates, cash-rich companies, China, and technology – that
we think will be key.
Contrary to the growing consensus that developed markets are the place to be this year,
we still prefer emerging markets. In our judgement, not only are growth prospects better,
but valuations are cheaper and risk (as measured by stock market volatility) is lower. We
don’t accept the argument that too much money has already gone into EM. Rather, we find
that investors are structurally very underweight: global funds have only 9.5% of assets in EM
– and US investors only 2.8%. Our preferred emerging markets are Russia, Brazil, South
Africa, Korea and Taiwan. Within developed markets, we favour the US, which we raise to
overweight. We are underweight Europe, but less negative on Spain, Germany, and Sweden.
Our sector recommendations remain pro-cyclical. We prefer capex plays to consumption
and so stay overweight the industrials sector. We think growth sectors are undervalued and
consequently raise IT to overweight. We continue to like dividend income in an environment
of low rates and so stay overweight telecoms.
Investment strategy
We expect 2011 to be a year with fewer macro surprises, where
stock selection and spotting the right themes will be key
Earnings are unlikely to be revised up much, but valuations could
rerate a little as the world returns to something like normality
We expect global equities to rise 11% in 2011, after 10% in 2010,
and continue to favour emerging markets, which remain structurally
very under-owned
A calmer third year
It seems like only yesterday, but it is now almost two
years since stock markets bottomed after the 2007-
2009 Great Recession. Since the trough on 9 March
2009, global equity markets have risen by 90%.
Last year was hard, though – as we warned it
might be in our 2010 preview, That Tricky Second
Year, published last January. The second year of a
bull market is typified by a slowing of growth
momentum after the initial rebound, doubts over
whether recovery is sustainable, and the side-effects
from measures taken to end the recession (most
often worries about the end of accommodative
monetary policy).
All those things happened last year: there was a
16% correction in the global market in April-June,
the global economy hit a soft patch in the summer,
and the extraordinary fiscal and monetary measures
taken to rescue the economy in 2008 came back to
haunt in the form of a sovereign debt crisis in
Europe and inflation in emerging markets. Given
how big the last recession was, it is hardly surprising
that the side-effects were bigger than usual, too.
Notwithstanding the ups and downs, global
equities still managed to rise 10% in 2010. That
return was driven by very strong earnings growth
(the 12-month forward EPS rose 24% during the
year) but limited by a big derating (forward PE
fell to about 12x from 14x). Again, that is not
untypical of the second year of a recovery: the same
combination of strong earnings growth but falling
PEs characterised 2004 and 1994, too
What happens in year three
So, as we prepare to enter the third year of the
recovery, what does that typically look like?
Earnings growth tends to slow to a more
sustainable pace after the initial earnings recovery.
The consensus currently forecasts 15% EPS
growth for the MSCI All Country World Index
(ACWI) in 2011, after 38% growth in 2010, and
between 13-17% for all the major regions and
countries (Chart 3). Those forecasts seem to us
reasonable, but it is fair to say that they are
unlikely to be revised up much.
PE tends to fall a little further in year three (see
the examples of 2005 and 1995 in Chart 2), but
that may not happen this time, since valuations are
already low by historical standards. The forward
PE for MSCI ACWI, at 12.3x, is well below 1
standard deviation from its long-run average
(Chart 4). In previous third years, it was much
more expensive: at the start of 2005 it was 15.1x
and in 1995 15.8x
The combination of positive, but somewhat slower,
earnings growth and some multiple contraction
means that year three has tended to produce positive
but unspectacular returns. Table 5 shows our
analysis of the third year of bull markets in major
countries going as far back as we could obtain
data (1932 for the US, 1970 for other markets).
On average, equity markets rose 4% in year three,
although this improves to 6% if we exclude Japan
and to 19% if we exclude episodes in which the
bull market lasted less than three years. One key
question, then, is whether the stock market
recovery will end this year – we will come back to
that later. Note, too, that in every market (except
Singapore) the current PE is significantly lower
than is typical at the start of year three.
The performance of stock markets in year three is
explained by the way the cycle tends to behave.
Chart 6 shows the pattern of the US manufacturing
ISM – in our view, the best simple indicator of the
global economic cycle – around the end of
recessions since 1950. After a strong initial
rebound from the recession, the pace of recovery
tends to peak after about 12 months. Then, in year
two, slowing growth momentum often causes
jitters in the equity market, as mentioned above.
In year three, on average at least, ISM is typically
stable at the 50-55 level, which indicates moderate
but steady expansion. The current recovery (which
began in the US in July 2009) does not look very
different to the typical pattern.
For 2011, all this means that if earnings growth
comes in somewhere close to the current consensus
forecast of 15% and multiples stay flat or even
rerate a little, global equities should be able to
produce decent double-digit returns – very much in
line with the historical pattern. Our index targets
(see page 2) imply a 11% rise in the MSCI ACWI
over the year.
What this means for investors
This suggests to us that 2011 will be a more stable
year, in which earnings and economic growth are
steady, but not particularly surprising. Our
economists, while they worry about the lingering
implications of structural deficiencies in the global
economy (see A mis-firing growth engine, 1Q11),
expect solid GDP expansion this year: 3.4% in real
terms in the US, 1.5% in the eurozone and 6.4%
in emerging markets.
The structural problems won’t go away quickly.
But, as time goes on, they will lose their ability to
shock. It is not unlikely that this year will see
further problems in US real estate markets, debt
restructuring in Europe or further upward pressure
on inflation in emerging markets. But how much
would such episodes surprise investors? Unless
the magnitude of these shocks is much bigger than
currently envisaged – or shocks emerge from
unexpected quarters – the degree of macro risk in
2011 is likely to continue to decline.
The view
Global equities to rise by 11% in 2011 driven by another year of
double-digit earnings growth
Continue to prefer EM over DM; raise US to overweight; cut Asia
ex-Japan to neutral; stay underweight Japan and Europe
Maintain a pro-cyclical bias at sector level with a preference for
capex plays and those offering an attractive income; overweight
energy, industrials, telecoms and IT (up from neutral)
11 in 11
We see the bull market continuing in 2011 with
global equities gaining a further 11%. The key
driver behind this rise is another year of healthy
corporate earnings growth.
Implicit within our forecast is our belief that the
trend de-rating that has taken place over the last
10 years has now run its course. Note we are not
looking for any meaningful re-rating here –
although this should not be ruled out given the
low starting-point for valuation and our forecast
of a more stable macro environment – but simply
that the equity market rises broadly in line with
earnings growth in 2011.
As we discussed in the Investment Strategy
section above, we see the consensus view for
global earnings to rise by 15% in 2011 as being in
the right ball park for a number of reasons. And
although this limits the scope for further earnings
upgrades, crucially in our minds it should be wellreceived
by those (many) sceptical investors that
do not believe the numbers.
In summary, our strategy (at both the regional and
sector level) continues to be consistent with the
“new normal” investment world we are facing –
low growth in DM, low inflation, ultra-low
interest rates – which we discussed in detail in our
previous Quarterly.
Strategy in bullets
Global equities to rise by 11% by end 2011
Stay overweight EM and raise US to
overweight
Cut Asia ex-Japan to neutral; stay
underweight Japan and Europe
Prefer capex over consumption plays,
continue to search for sustainable yield and
increase exposure to the growth theme
Overweight: energy, industrials, telecoms and
technology
Underweight: consumer discretionary,
consumer staples, utilities
Below we present our market scorecard, which we
use to add some further discipline to our market
weighting process. Note, this is not intended to be
a quantitative model but rather a tool to help us
systematically assess the factors that will drive
market performance over the coming quarters.
We use objective numerical measures to gauge
three categories: “Loved/unloved”, valuation and
dividend yield. The underlying data for these
categories are shown in the tables on the
following page.
With “Loved/unloved” we look to gauge the
degree of optimism about each market. We
consider a combination of aggregate sell-side
analyst recommendations and the position of
global and regional mutual funds compared with a
MSCI index benchmark. To account for any long
term structural over- or under-weights we
calculate current positions relative to their long
term average. As these measures represent
contrarian indicators, optimistic positions are
assigned a low score in our final scorecard table.
For Valuation we look at each market’s forward
PE relative to that of the MSCI All Country World
index. Final scores are assigned based on the
deviation of this measure from its long-term
average. For this factor we have made a manual
adjustment in the case of Japan due to the (deserved)
de-rating it has experienced over the past 20 years
– we have assigned the market a score of ‘-1’
rather than the ‘2’ the raw data suggests.
Dividend yield simply reflects the current
absolute dividend yield for each market. The highest
score, 3, is assigned to any market with a dividend
yield greater than 4%, while a 0 is assigned to
dividend yields lower than 1.5.
The remaining factors are more of a judgement call
based on our discussions with HSBC analysts and
economists, and on examining a range of data. These
factors are discussed in detail in the individual
country comments that follow.
EM (stay overweight)
We continue to prefer EM to DM. Arguably this
could be viewed as being a more contentious call
than it was, say, in 2010. This is because in the
case of developed markets (DM) the growth outlook
is now starting to look less fragile and, in the case
of many emerging markets (EM), investors are
becoming concerned about overheating and the
associated monetary policy response.
However, while we have some sympathy with
these views we feel that they are more country
specific. For example, even though the US growth
outlook for 2011 looks stronger, the same cannot
be said for other important DM regions such as
the eurozone and Japan where the recoveries still
look vulnerable to further setbacks. And in the
EM world, overheating concerns appear to be
more relevant for, say, a country like India than
they are for say Russia.
It follows that in setting our country calls we have
taken on board stronger growth profiles in certain
developed markets (notably the US) and monetary
policy risk in certain EM markets (India and
China). However, we feel that these developments
are not significant enough at the regional level to
warrant a shift in preference. We therefore stay
overweight EM because of the long-term
structural arguments in favour, as set out in the
Investment Strategy section above.
Our preferred markets within the EM region are:
Taiwan, Russia, Korea, South Africa and Brazil.
The key reasons why are as follows and should be
viewed alongside our HSBC market scorecard on
page 21:
Taiwan (overweight)
Our upgrade of the global technology sector
(around 60% of MSCI Taiwan) clearly helps
this market and it also scores consistently
well across our scorecard categories, in
particular on the potential for a positive
growth surprise (as the world trade cycle
gains momentum) and the long-term story.
Newsflow also likely to be supportive as a
result of improving cross-Strait relations.
Russia (overweight)
A global cyclical market that is sensitive to
the improving economic outlook and general
pick-up in risk appetite. We are overweight
energy (55% of MSCI Russia) and the oil
price is moving higher. The market also
scores particularly well on valuation in our
scorecard.
Korea (overweight)
The market looks cheap (as always) but we
see the potential for a re-rating as the focus
shifts from brand build-out to profitability.
Conflict concerns remain but are not unusual
and often provide a good entry point for
equity investors. Like Taiwan, the Korean
market is sensitive to the global trade cycle so
a further improvement here could produce a
positive growth surprise.
South Africa (overweight)
Market has scope to benefit from both
cyclical, and to some extent structural,
surprise. A strong rand and significant output
gap suggest that this market is not at risk from
inflation and monetary policy pressure.
Brazil (overweight)
A lot of negative news has now been priced in
on domestic and Chinese overheating, but
plenty of near-term catalysts remain: the
external environment is becoming more
positive and the structural growth story is
very strong. The market lagged last year and
no longer looks expensive in the EM world
for the kind of growth it is delivering.
US (up to overweight from neutral)
We raise the US to overweight from neutral
on the back of an improving growth outlook,
ultra-accommodative monetary policy and
low valuations for this point in the cycle.
This equity-friendly environment is reflected
in our scorecard with the US scoring
consistently well across the various
categories, in particular on monetary policy
where it is top ranked.
The corporate sector continues in a position
of strength with top-line growth coming
through but at the same time labour and
financing cost pressures remaining anaemic.
This has resulted in companies consistently
beating consensus expectations (true for the
last six quarters) and we expect more of the
same in 1Q11.
Europe (stay underweight)
We stay underweight on Europe as we
continue to see better opportunities elsewhere.
The call worked well in 4Q with the region
being the worst performer across our global
categories.
It does look cheap on an absolute basis with
our cyclically adjusted PE indicating that the
market is trading at around 20% below its fair
value.
The problem is that the growth/policy tradeoff
looks less attractive here than it does in
the US, with growth expected to be lower in
Europe and both fiscal and monetary policy
less supportive.
Europe does perhaps have the greater
potential to surprise on the upside given that
the sovereign debt story is well known but we
cannot ignore that the risks of a further
setback to growth are clearly greater here
given the numerous austerity plans being
implemented across the region.
Spain (overweight)
Spain is the only European country that we
have as an overweight in our global universe.
We turned positive at the height of the
eurozone sovereign debt crisis in 2Q and it
has been a roller-coaster of a ride with a
strong relative performance in 3Q offset by a
weak one in 4Q as general eurozone
periphery concerns resurfaced. The central
view of our bond strategists remains that
these debt concerns are overdone in the case
of Spain. Furthermore, macro issues aside, we
continue to like the equity market because of
both its high exposure to EM and the dividend
on offer – in our view a prospective 2011
yield of 6.5% in the ‘new normal’ is too
attractive an income to be overlooked.
Elsewhere, we are neutral on both Germany
and Sweden primarily because both markets
have good exposure to the capex theme which
we expect to be a key one through 2011. We
are also neutral on the UK because of its
relative policy flexibility, exposure to
resources (we are overweight energy) and
attractive dividend yield of c4% for 2011.
All other European markets are underweight
and – aside from offering attractive dividends
– generally struggle across our scorecard
categories. Note, we still see value in these
markets and see them rising in absolute terms
(in the +5 to +10% range) but by less than the
global market (+11%).
Asia ex-Japan (cut to neutral)
We cut Asia ex-Japan to neutral. The longterm
story undoubtedly remains a strong one
across the region but the monetary policy
headwind that certain markets are facing (as
discussed in the EM section above) points to a
more cautious stance in 1Q11. This is a key
reason why we remain unenthusiastic about
the Indian (underweight) and Chinese
(neutral) equity markets where we see policy
risk as being higher.
We prefer the export markets of Taiwan
(raised to overweight) and Korea (remain
overweight) where the policy risk is lower
and where we see more potential for growth
to surprise on the upside as the world trade
cycle gains momentum (see EM section
above for a further comment on these
markets). Elsewhere within the region we cut
Australia, Hong Kong and Singapore to
neutral.
Japan – stay underweight
In our view, it is not time to reconsider Japan
and we stay underweight.
The fundamentals remain weak, valuations
are not cheap and the Bank of Japan has been
too cautious on rolling out QE. In addition,
the strong JPY, which is still 40% below the
peak of 1995, could appreciate further
impairing Japanese exports.
Japan scores consistently poorly on our
scorecard (in particular on the long-term
story) and with Global ex-US funds already
slightly overweight, we do not see any strong
reason for funds to increase their Japanese
holdings.
Sector allocations
For our sector recommendations we use the
same scorecard methodology as our country
analysis. This scorecard is presented in the table
below, and the underlying data for the
numerical measures are shown in tables on the
following page.
We are playing the three individual themes that
are consistent with the “new normal” investment
world we are facing – a preference for capex
over consumption plays in DM, sectors offering
an attractive and sustainable yield and sectors
offering through-the-cycle growth.
Our key overweights (at the broad MSCI sector
level) are: energy, industrials, technology and
telecoms. Of these, technology (up from neutral)
is a new addition.
Elsewhere, we stay neutral on financials,
materials and health care and remain cautious on
the consumer sectors and utilities with
underweight positions.
Energy – overweight
The oil price is edging higher and we
suspect that OPEC has unofficially raised
its target band is response to the rising price
of non-oil commodities which many OPEC
countries are net importers of. We do not
see a significant breakout in either direction
which may lead to some increased
confidence regarding future cash flow and
dividend sustainability.
The sector scores generally well across our
scorecard categories. It remains relatively
unloved but its dynamics are turning
positive (as highlighted by the second best
performance in 4Q of the ten broad MSCI
sectors).
The services sub-sector is another play on
the capex theme and should continue to
benefit as the market refocuses on the
growth potential of the sector.
Industrials – overweight
We stay overweight industrials. The capex
cycle is only just turning up and has much
more upside in our view.
Corporates are swimming in cash and we
expect the pressure to rise on firms to either
use it (invest it via capex and M&A) or lose
it (return the money to shareholders via
buy-backs and dividend payments). This
provides the potential for a growth surprise
in 2011.
The sector is relatively loved by the sellside
and the valuation is not as attractive as
other parts of the market, but we feel that in
an uncertain macro environment the
increased visibility provided by this
developing theme is worth paying up for.
Capital goods is our preferred play within
the sector. Here we expect further EPS
upgrades alongside a general re-rating of
the sector as the market takes note of its
growth attribute.
Telecoms – overweight
The telecoms sector offers the most
attractive yield in the global sector universe.
As risk appetite picks up and the search for
yield in a low/zero interest rate world
gathers pace, we expect increased demand
for higher yielding equities.
Aside from the yield attractions, cash flow
visibility is positive and more significantly
our sector analysts are seeing tentative
evidence that the sector is finally getting its
act together in terms of pricing – we are
seeing the early stages of a shift to tiered
plans as the scarcity of capacity on mobile
networks becomes more apparent with the
success of the popular smart phones.
This gives a potential ‘growth carrot’ to a
sector that is being priced as a utility and if
it can monetise this scarcity then it should
experience a rerating.
Technology – overweight
We are turning more positive on technology
and we raise the sector to overweight from
neutral.
We see this sector as having growth
characteristics and we see growth as a
developing theme in 2011. The sector looks
cheap and also scores well on expected
newsflow and the potential for an upside
growth surprise.
We particularly like the parts of the
technology space (in particular the subcomponent
plays) that are exposed to the
‘techtonic’ shifts we are seeing in the
development of mobile phone handsets
(smartphones), televisions (LED and 3D)
and tablets.
Another area within the technology space
that we continue to find particularly
attractive is telecommunication equipment.
This is based on our sector team’s ‘capacity
crunch’ view – where the rise of smart
phones and data usage is leading to a
scarcity in mobile network capacity which
will subsequently trigger a rise in capex
from the operators and therefore a rise in
demand for the equipment manufacturers.
Financials – neutral
We maintain a neutral position on the
financials sector. The sector trades on a low
valuation but risk remains high across the
constituent industries.
On banks specifically, aside from the
improving economic outlook which should
continue to reduce impairments, there are
other potential catalysts such as greater
clarity on Basel rules and more detail on
mitigation efforts. But uncertainty on all
these areas remains high, particularly in
Europe where we have the added
complication of the sovereign debt crises –
a reason why we prefer the Swiss
investment banks in this region with their
lower exposure to the periphery and greater
regulatory certainty.
Elsewhere, we see insurance as also
offering value but again uncertainty is
likely to remain high until we get greater
clarity on Solvency II risk and see
improvements in terms of disclosure.
Materials – neutral
We stay neutral on materials. The sector has
got very strong momentum but it is ‘loved’
and is no longer cheap relative to the
market, as it was when we went overweight
back in mid-2010.
We have a structurally positive view on the
mining industry due to excess cash
generation, a product of repaired balance
sheets, improved productivity and better
commodity prices. However, cost pressure
is now rising and adding to this will be a
return to peak rates of capital spending –
supporting our strategy of preferring the
more capex exposed parts of the cyclical
space (industrials).
On chemicals we see the outlook as being
positive over the next 12-months: demand
remains firm in EM and we expect to see
some improvement in DM beyond 2011.
Pricing power and cost savings are likely to
more than offset rising raw materials prices
leading to almost record cash generation.
Elsewhere, we expect building materials to
benefit from EM growth but construction
markets in US and Europe are likely to
remain depressed with cost savings only
partially counteracting energy cost
increases and modest price weakness in the
US and Eastern Europe. Stagnation in the
housing market is another negative.
Healthcare – neutral
We remain underwhelmed by healthcare
and stay neutral.
Patent and pipeline issues should be well
known and the sector does look relatively
cheap. But with western governments
looking to defuse exploding budget deficits
the risk is that pressure on health care
spending may intensify. This provides the
potential for negative newsflow through
2011.
Consumer discretionary –
underweight
We stay underweight on consumer
discretionary. Even though the headwinds
facing developed market consumption are
well known, we feel that the risk-reward
balance is far more attractive in the
industrials space (via its exposure to the
capex theme).
On the retail side we see uncertain western
consumer demand and rising Chinese input
costs combining to produce a difficult
environment for the sector as we move into
2011.
We prefer media, where our sector team’s
correlation analysis of leading indicators for
ad spend continue to point to growth.
On luxury goods, we are now seeing a new
‘new normal’ with luxury demand
increasing at a double-digit rate over the
next two years with visibility. Also, seeing
resilience from high-end consumers in the
more difficult developed world market. The
problem is that this is a crowded trade and
one of the most obvious plays on EM
growth – reflected in a stellar performance
yet again in 2010.
Consumer staples – underweight
We stay underweight on consumer staples
primarily on valuation grounds.
Investors seem keen to play the food retail
sector, anticipating a return to higher
inflation rate. However, we have our doubts
and even if the inflation rate does pick up in
2Q11 we do not expect it to be sufficient to
drive sector valuation.
We also do not see the food producers as
being particularly appetising given their
lofty valuations. Furthermore, input cost
pressure from rising soft commodity prices
is a threat to margins at a time when the
consumer demand environment is likely to
get more difficult in DM.
Utilities – underweight
We maintain our underweight position on
utilities with the sector continuing its poor
run through the fourth quarter – the worst
performer in the global universe.
The yield is the second most attractive in
the market behind telecoms but the
valuation does not look appealing.
Furthermore, the potential for dividend
growth remains limited with surplus cash
being swallowed up by capex plans.
The potential for shocks also remains
relatively high in our view, as a result of
ongoing regulatory uncertainty and fiscally
challenged governments looking for new
revenue streams.
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