Global Horizon -Fed cooks up second half sizzle \:: Macquarie

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Global Horizon
Fed cooks up second half sizzle    
Event
ƒ We update our equity risk premiums models for the US, Europe and emerging
markets. The risk premium is equal to the estimated Internal Rates of Return
(IRR) for each market calculated using Macquarie’s Composite Discount
Model, less the relevant 10-year government bond.
Impact
ƒ The risk premium for emerging markets is 7.7% relative to US bonds, which
is more than 1 standard deviation above the mean. Historically (1995 to 2011)
the average 12-month forward return in similar periods is 31%, although the
volatility of returns is also higher at almost 50%.
ƒ There are two important points to note in regard to the EM risk premium. 1)
Forward 12 month returns in EM are positively related to the level of the risk
premium (see chart on left), which is a contrast to the US, where the volatility
of returns increases with the premium. 2) There is a strong negative
correlation (minus 84%) between the EM risk premium and US bond yields,
which suggests emerging markets will perform better when US interest rates
rise, and money flows from bonds into US and global equities.
ƒ After rising over the start of the month as equity markets declined, the United
States equity risk premium ended the month back where it started at 5% as a
result of a month end rally in equities and a rise in bond yields. At 5%, US
equities are on the cheap side of fair value.
ƒ The equity risk premium for Europe relative to German bonds was 7% at the
end of June, up ~30 basis points over the month. While more than 1 standard
deviation above the mean, it’s critical to note the series shows little mean
reversion, and currently, the risk premium is trending higher.
Outlook
ƒ We continue to expect improved growth and sentiment to drive a second half
rebound. That said, we see ongoing market volatility in coming months and,
while nearing the end of the move, we still suggest a defensive strategy with
some key picks being: Telefonica (TEF SM), RWE (RWE GR), Sainsbury
(SBRY LN), Verizon (VZ US) and Sanofi (SAN FP).
ƒ The results of our research into the equity risk premium confirm the
conclusion of our global strategists that emerging markets are likely to be the
strongest performers in the anticipated second half rebound in equity markets.
We expect the countries with the most upside will be externally focused
economies such as Korea and Taiwan.
ƒ Given the link with US bond yields and EM returns the direction of US yields is
a key catalyst for upward momentum, and the next signal on rates is likely to
come at the Fed’s Jackson Hole meeting in August. Talk that higher rates are
needed would be positive for global equities, as changes in Fed policy are
generally a good leading indicator, and our research suggests emerging
market equities have the most leverage to a rebound.