Global Market. Commentary. Time to Pause. August 17, 2012

Transcription

1 Global Market Commentary August 17, 2012 Richard Golod Director, Global Investment Strategies Time to Pause Executive summary Statements from the heads of central banks across the globe helped move global equity markets higher last month. I believe the recent rally may have created an inflection point that could potentially limit the equity market s downside. That said, the market s upside could also be constrained, at least in the near term, in my opinion. This month s commentary provides some perspective on this environment for longterm investors. Overweight US. Recent positive economic and market developments have probably taken a third round of quantitative easing (QE3) off the table for now. I believe a delay in additional easing could also delay the equity markets continued advance in the short run. Although improvements in the Economic Cycle Research Institute (ECRI) Weekly Leading Index and the Citi Economic Surprise Index for G10 countries would suggest adding additional risk to portfolios, this trading opportunity may be too brief for investors to capitalize. Rather, I believe long-term investors should continue to add high-quality, dividend-paying, large-cap companies to equity portfolios. Neutral weight Europe. Supportive statements from European Central Bank (ECB) President Mario Draghi and German Chancellor Angela Merkel have propelled European equity markets lately. Although I believe market lows could be behind us, economic data and market sentiment indicators remain in decline. This warrants continued defensiveness in European equities, in my view, with a focus on highquality, dividend-paying, large-cap multinationals. Overweight emerging markets. The asset class is likely to remain out of favor with investors until there is more clarity on the European debt crisis and enough time elapses for any additional policy stimulus to work through the economies. However, I believe emerging market equities still have one of the most attractive risk-reward profiles for investors with the appropriate risk tolerance who are seeking the potential for long-term growth. The following pages expand on these insights and examine the implications for global equity investors.

2 Central banks helped sustain global equity rally Global equity markets continued to rally into August as investors gained confidence about central banks intentions to address the global economic slowdown. Investors believed ECB President Draghi reduced the tail risk that is, an extreme level of risk in the eurozone after stating at the Global Investment Conference in London on July 26 that the ECB is ready to do whatever it takes to preserve the euro. His comment was reiterated by Chancellor Angela Merkel and French President Francois Hollande. In August, US Federal Reserve Board Chairman Ben Bernanke intimated that additional stimulus may be forthcoming if needed, and China s Premier Wen Jiabao said there is growing room for monetary policy operation. As a result, global equities (as measured by the MSCI World Index) have rallied 12% since the June 4 low, European stocks (as measured by the MSCI Europe Index) rallied 17% and the S&P 500 Index is up 10% as of Aug For US equities, the rally has reduced the extreme valuations (as measured by dividend yield spread, the difference between the dividend yield on the S&P 500 Index and the yield on 10-year Treasury bonds) and equity risk premium that existed in the S&P 500 Index in June. In addition, the rally has eased the level of pessimism among other measures of investor sentiment, including the New York Stock Exchange s (NYSE) short interest volume (as measured by the NYSE Short Interest Ratio) and the NYSE put-call ratio. 2 With the recent rally, I believe investors may have seen an inflection point that could potentially limit the equity market s downside. With the recent rally, I believe investors may have seen an inflection point that could potentially limit the equity market s downside. But is there more upside this year? US: overweight Although the S&P 500 Index has remained in an uptrend since the index crossed above its 200-day moving average (an important technical level) on Dec. 19, 2011, it wouldn t surprise me to see some profit taking in September as additional monetary stimulus (QE3) seems less likely. The economy isn t weakening enough to announce another round of easing any time soon, but it s also not strengthening enough to take the possibility off the table, in my opinion. Consider some of the positive economic announcements in recent months: Retail sales surprised on the upside in July with the first increase in four months, reflecting broad-based gains and reducing concerns that the consumer will retrench. 3 After six years of negatively affecting gross domestic product (GDP) growth, residential housing has contributed positively the past five quarters. 4 The National Association of Home Builders/Wells Fargo Housing Market Index, a measure of homebuilders sentiment, is at a five-year high as of its August reading. 5 US building permits jumped to their highest level in four years, suggesting that the real estate and construction sector could remain strong throughout the remainder of the year. 6 Job openings are at the highest level in four years. 7 Unemployment claims are the lowest in four months. 8 The ECRI Weekly Leading Index, while still slightly negative, has improved five consecutive weeks. 9 The Citi Economic Surprise Index for G10 countries (at on Aug. 17) has been trending higher since the July 19 low of However, not all economic announcements have been positive. Second-quarter GDP growth came in below expectations. Consensus forecasts for GDP and earnings continue to decline. Lastly, the recent increase in food and gas prices will likely temper the increase in real disposable income. Until investors gain a better sense of the direction of the economy and see reduced tension in the Middle East and further progress in Europe, it wouldn t surprise me to see the S&P 500 Index trade in a tight range for a couple of months. At current levels, 2 Global Market Commentary: Time to Pause

3 I believe the Chicago Board Options Exchange Volatility Index (a measure of market volatility known as the VIX) suggests the S&P 500 Index may struggle to move higher. Therefore, although some recent data could support adding risk to portfolios, I believe investors should remain defensive, opportunistic and selective. Therefore, although some recent data could support adding additional risk to portfolios, I believe investors should remain defensive, opportunistic and selective. Investors should continue to overweight high-quality, dividend-paying, large-cap stocks in the noncyclical sectors, in my opinion. Europe: neutral weight The European equity markets (as measured by the MSCI Europe Index) rallied the past 10 weeks (as of Aug. 17) and are trading at the highest levels since March The Euro Stoxx 50 Index, a measure of eurozone blue chip stocks, is up 19% since the June 1 low, as of Aug Fueling these gains were factors such as UK retail sales beating forecasts, German and French GDP exceeding expectations and hedge funds covering short positions a trading strategy employed when there is speculation that the share price could rise at the fastest pace in three years. 12 That said, the eurozone economy contracted in the second quarter for the first time since July was the sixth consecutive month that output in eurozone manufacturing and services declined. 14 Germany, which accounts for roughly 27% of the euro area s output, has seen slower growth in each of the past five quarters. 15 German business confidence (as measured by the Ifo Business Climate Index) fell to the lowest point in two years in July. 16 The German ZEW Indicator of Economic Sentiment slipped in August to 25.5 from 19.6, its third decline in a row. 17 For the region as a whole, analysts have slashed profit forecasts at the fastest rate since 2009, and 2012 consensus earnings estimates have been reduced to 5% from 19% at the beginning of the year. 14 Economic and profit decline in Europe is not a surprise to anyone. In my opinion, the primary drivers of the recent equity rally have been changes in the equity risk premium, which were prompted by the comments from Mr. Draghi and Ms. Merkel, and expectations for Spain to accept a bailout and for further austerity in Greece. I suspect the saga will continue in the eurozone, but the tail risk has likely been taken off the table for now. The market lows could be behind us, in my opinion. It has been my position that the euro will survive and euro leaders will step up when a crisis insists on action, but only at the eleventh hour when the euro s survival depends on it. I suspect the saga will continue in the eurozone, but the tail risk has likely been taken off the table for now. The market lows could be behind us, in my opinion. I believe investors with the appropriate risk profile should consider adding high-quality, large-cap, dividend-paying European multinationals to equity portfolios. Emerging markets: overweight The MSCI Emerging Markets Index has continued to underperform the S&P 500 Index year-to-date (as of Aug. 17). 18 The BRIC (Brazil, Russia, India and China) economies continue to feel the strain from problems in Europe and, in the case of Russia, lower energy prices and rising inflation. China s economic slowdown will likely extend to seven quarters as industrial production and lending fell short of expectations, and export growth collapsed in July. 19 Foreign direct investment fell to the lowest level in two years. 19 In June, India s PMI (purchasing managers index) fell to its lowest level in eight months. 20 However, inflation fell to a 32-month low in July, leaving room for additional policy stimulus, which I believe could positively affect the equity markets Global Market Commentary: Time to Pause

4 Brazilian equities rallied 12% from the June 1 low to Aug. 17 in anticipation of additional policy stimulus in China, a major export market. 22 However, economic data in Brazil remain weak, with industrial production falling, disappointing exports and little improvement in loan growth. It would appear the equity market is ahead of fundamentals. Russia is going through a real estate boom, with housing prices up 18.2% (seasonally adjusted) in the second quarter. 23 This, in turn, has spurred consumer spending and threatens to overheat the economy. Monetary policy is likely to remain in favor of higher interest rates. The fact is, according to research by Goldman Sachs, the global business cycle entered a contraction phase in April and has remained there. 24 I believe emerging market equities are likely to continue to underperform in such an environment, especially when investors are reducing risk assets in portfolios. Investors are unlikely to meaningfully add to riskier assets such as emerging market equities until any additional policy stimulus is given time to work through these economies and more progress is seen in Europe. I believe emerging market equities still have one of the most attractive risk-reward profiles for investors with the appropriate risk tolerance who are seeking long-term growth. As mentioned in last month s commentary, relatively cheap emerging market equity valuations have limited the downside. 25 Additional policy stimulus is in the offing, in my opinion, and could be constructive for higher equity prices. I believe investors with the patience to hold emerging market equities for the long term should continue to add to the asset class while it appears undervalued. I believe emerging market equities still have one of the most attractive risk-reward profiles for investors with the appropriate risk tolerance who are seeking the potential for long-term growth. Final thoughts The global economy is growing at a paltry pace, but recent data announcements indicate the slowdown may be behind us. If the Citi Economic Surprise Index and the ECRI Weekly Leading Index continue to improve, these conditions could support a case for higher equity prices and justify adding more risk assets to portfolios, in my opinion. Although the global equity markets have been in an uptrend, I am concerned investors could be temporarily disappointed by waning expectations for QE3, a lack of detail in solving Europe s sovereign debt crisis and continued economic weakness in the emerging markets. Therefore, I would forgo adding additional risk to portfolios and instead remain opportunistic and selective and continue to add high-quality, large-cap, dividend-paying, multinational stocks from around the world. Important information The opinions referenced above are those of Richard Golod as of August 17, 2012, and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Past performance is no guarantee of future results. All investing involves risk including the risk of loss. Diversification does not eliminate this risk. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Small- and midcap stocks carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer s board of directors and the amount of any dividend may vary over time based on the business prospects of the company. This material is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor. It is not a solicitation or an offer to buy or sell any security or investment product. 4 Global Market Commentary: Time to Pause

5 1 Source: Bloomberg L.P., Aug. 15, Source: Bloomberg L.P. and Invesco research, Aug. 15, 2012; Bloomberg L.P., July 31, 2012; and Bank of America/Merrill Lynch, Aug. 14, The New York Stock Exchange (NYSE) Short Interest Ratio is a monthly measure of the amount of shares sold short on the exchange divided by the average daily volume of the NYSE for the past month. The indicator is used as a gauge of investor sentiment. A high short interest ratio indicates bearishness among traders, while a low short interest ratio indicates bullishness. The put-call ratio measures the trading volume of put options to call options and is considered an indicator of investor sentiment. When traded call options exceed traded put options, market sentiment is considered bullish. When put options exceed call options, sentiment is considered bearish. 3 Source: Bloomberg L.P., July 31, Source: Ned Davis Research, Inc., Aug. 8, Source: Bloomberg L.P., August Source: Ned Davis Research, Inc., Aug. 8, Data as of June 30, Source: Bloomberg L.P., June 30, Job Openings and Labor Turnover Survey, or JOLTS, is compiled by the Bureau of Labor Statistics from a monthly survey of nonfarm business establishments in both the public and private sectors about total employment, job openings, hires, quits, layoffs and other discharges and separations. 8 Source: Bloomberg L.P., Aug. 10, Source: Wolfe Trahan & Co., Aug. 7, Source: Bloomberg L.P., Aug. 17, Source: Bloomberg L.P., Aug. 17, Source: Bloomberg L.P., Aug. 17, 2012; European Stocks Climb to Highest Since March; Novozymes Advances, Bloomberg News, Aug. 16, 2012; Hedge Funds Capitulate on European Shorts Fastest Since 2009, Bloomberg News, Aug. 13, 2012; and Gluskin Sheff, Aug. 15, Source: Bloomberg L.P., June 30, Source: Hedge Funds Capitulate on European Shorts Fastest Since 2009, Bloomberg News, Aug. 13, Source: Hedge Funds Capitulate on European Shorts Fastest Since 2009, Bloomberg News, Aug. 13, 2012, and Bloomberg L.P., June 30, Source: Bloomberg L.P., July 31, Source: Bloomberg L.P., August Source: Bloomberg L.P., Aug. 17, Source: Investment in China Slides as Wen Sees Room for Easing, Bloomberg News, Aug. 16, Source: Gluskin Sheff, Aug. 1, Source: Retail Sales in US Jumped More Than Forecast, Bloomberg News, Aug. 14, Source: Bloomberg L.P., Aug. 17, Source: J.P.Morgan Chase, Aug. 3, Source: Goldman Sachs, Aug. 10, Source: BRICs Priced for Economic Meltdown as Value-to-GDP Gap Grows, Bloomberg News, July 3, Global Market Commentary: Time to Pause

6 The Economic Cycle Research Institute (ECRI) Weekly Leading Index is an economic indicator used to forecast turning points in the economic cycle, similar to the Conference Board Leading Economic Index (LEI) but updated more frequently. The Citi Economic Surprise Index for G10 countries measures how a variety of macro indicators surprise relative to expectations for the countries included in the Group of 10 (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the UK and the US). The MSCI World Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indexes: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK and the US (as of May 31, 2011). The MSCI Europe Index is a free-float-adjusted market-capitalization-weighted index designed to measure the equity market performance of the developed markets in Europe. The MSCI Europe Index consists of the following 16 developed market country indexes: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK (as of May 30, 2011). The S&P 500 Index is an unmanaged index considered representative of the US stock market. The National Association of Home Builders/Wells Fargo Housing Market Index measures homebuilders sentiment about the sales conditions for single-family homes, based on surveys conducted by the National Association of Home Builders. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, shows the market s expectation of 30- day volatility. The VIX is a widely used measure of market risk and is often referred to as the investor fear gauge. The Euro Stoxx 50 Index, considered the eurozone s blue chip index, measures the performance of 50 stocks from 12 eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. The Ifo Business Climate Index is a commonly cited early indicator of economic development in Germany. The ZEW Indicator of Economic Sentiment is based on a monthly survey of financial experts and reflects the difference between the number of analysts who are optimistic and pessimistic about their expectations for the Germany economy in coming six months. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey (as of May 30, 2011). PMI (formerly Purchasing Managers Index) is a commonly cited indicator of the manufacturing sector s economic health calculated by the Institute of Supply Management. An investment cannot be made in an index. invesco.com/us GOLOD-COM-8 09/12 Invesco Distributors, Inc