Op-Ed, Financial Times: Peter Oppenheimer - There is Plenty of Life in this 'Investable' Equities Rally
Amid all the angst over Spain's banking and fiscal crisis, the relative buoyancy of financial markets has passed almost unnoticed.
Such optimism in the markets may seem at odds with the stream of economic and budget gloom. But, in fact, the rally has been under way for some time. Despite the obvious headwinds of economic stagnation, the slowdown in the US and Chinese economies and the repeated speculation that the euro system may be about to collapse, equities have been among the strongest performing asset classes in the year to date. The MSCI World index has risen 14 per cent, the Stoxx Europe 600 is also up 14 per cent, while US Treasuries have returned 4.5 per cent (all in US dollar and total return terms).
One of the biggest explanations for these different returns comes down to valuation. After years of derating, equities may have reached a point where they have more than adequately reflected the economic stresses and risks brought on by the financial crisis. At the same time, the relentless decline in interest rates over the past three decades has pushed up the price of many government bonds to levels that no longer offer attractive returns to maturity.
Both the derating of equities (from unrealistic highs during the late 1990s technology bubble) and the re-rating of bonds (as inflation continued to surprise on the downside) were necessary given the starting points. The onset of the financial crisis has merely extended and exaggerated these trends as investors have become increasingly sceptical about the ability of economies to grow as they struggle with record amounts of debt.
The European sovereign debt crisis is the most recent in a long line of problems to have emerged as the huge global savings and investment imbalances have begun to unwind over the past five years. The European Central Bank's bond purchase proposal in August has helped to reduce some of the systemic risks associated with the debt crisis by finding a way to break the intractable political cycle that was acting as an obstacle to a workable solution.
It is clear that a fall in the equity risk premium (the additional rate of return investors require for investing in equities over and above what they can get on relatively risk-free assets such as bonds) has been the main driver behind the rally in risky assets since July. In July the equity risk premium was as high as 9 per cent. Over the past two months it has fallen to 8 per cent on our estimates. This is still very high by historical standards: the long-run average is close to 4 per cent. It is not surprising that the ERP remains unusually high, given the current macro dislocations, but our estimate of the appropriate level of the ERP is about 6.75 per cent.
We estimate a 1 per cent fall in the ERP, all else being equal, is worth about 20 per cent on the broad European equity indices. Although some of this may be achieved via a further rise in "risk free rates", such as for German Bunds, there still appears room for a further moderation of about 50 basis points over the coming months.
From a political perspective, the main risks may be shifting to the US given the impending "fiscal cliff" that the US is likely to reach by mid-February. Should Congress not act, the government would be forced into a drastic reduction in expenditures, pushing the economy into a recession that is not being priced into equity markets.
The other key driver for markets will be economic activity. Recent data suggest that the momentum of the global economy and, thus, corporate profits, remains moribund but is probably not deteriorating.
On the positive side, many central banks have increased their support through policy actions aimed at kick-starting growth. While there is a debate about the effectiveness of these policies, at least it is something.
Growth is unlikely to be strong in 2013, but risky assets typically perform well when the momentum and growth rate of the global economic cycle start to improve even if growth levels remain subdued. So far, such an improvement does not appear priced in.
While these issues will determine the trajectory and volatility in markets over the remainder of the year, the longer-term prospects are more positive, at least for equities.
Ultimately, what is most important is not just the pace of economic activity and corporate profit or dividend growth but the outcome relative to the expectations priced in.
After years of derating to correct the over-optimistic expectations of the late 1990s, the uncertainty associated with savings and investment rebalancing have left valuations at levels that imply an unrealistically negative scenario, as long as the worst political tail risks can be contained. That is still the "investable opportunity".
Peter Oppenheimer is chief global equity strategist at Goldman Sachs