Global equity valuations are still attractive

With the current equity market bull run about six years old, once buoyant investor sentiment has turned cautious in the wake of a significant increase in market volatility, and ahead of the expected lift-off in US interest rates.

However, global equity valuations are still attractive on a relative basis and should remain supported by accommodative monetary policies and the recovery in global growth.

Commenting on Novare Investments’ economic report for the first quarter of 2015, Francois van der Merwe, Head of Macro Research, said: “Markets are experiencing heightened levels of uncertainty and price movements as they digest the impact of higher interest rates.

“Despite signs that the global economy is on a more sustainable growth path, expectations have been pared back aggressively and actual growth has a probability of exceeding expectations over the coming year, especially in Europe. The main reason is that relative currency strength will act as a shock-absorber to distribute economic growth amongst different regions with the strong dollar pushing growth towards Europe.”

Despite the stronger dollar, Novare Investments remains positive on the US, where underlying momentum in the economy is solid. The firmer dollar will probably not prevent the Fed from hiking interest rates later this year, especially since the recent soft patch in economic data should prove temporary.

“Employment growth will remain healthy and inflation should head to the Fed’s targeted level. Interest rate hikes later this year do not mean that monetary policy will become restrictive. Instead, policy will remain rather accommodative as the Fed takes the focus away from the lift-off date, shifting it to the pace of increases which should be slow during this interest rate cycle,” said van der Merwe.

He added that there is a disconnect between the market’s pricing of future interest rates and where the Fed is predicting them to be. Financial markets, especially the fixed interest market, could undergo sharp adjustments if data surprise on the upside.

Across the Atlantic, Europe will benefit from reduced borrowing and energy costs and a more competitive exchange rate. Confidence levels have improved and credit extension has turned positive. While Greece is the wildcard, overall, European risks have receded.

According to van der Merwe, “Earnings momentum in the US will improve as the economy rebounds from its first quarter slump. European earnings revisions have turned positive for the first time since 2011 and profitability should be supported by a stronger economy.

“Global equity valuations have become more expensive on an absolute basis, but on a relative basis they still look attractive, supported by continued accommodative monetary policies and the recovery in global growth.”

US bonds look vulnerable to the onset of US monetary policy normalisation, while technical factors also bode poorly for bond performance. Short-term inflation and bond supply dynamics will support European bonds as the European Central Bank buys up most of the new issues and inflation is held down by lower energy prices.

In South Africa, the global backdrop will play a large role in the domestic economy through the remainder of the year. Tighter US monetary policy raises the risk of the reversal of foreign portfolio flows, and the SA Reserve Bank is positioning for interest rate hikes. These are not only to protect foreign portfolio outflows, but are necessary to fight inflation that is projected to head back to the upper limit of the targeted inflation band.

The amount of available electricity restricts the economy to potential growth of roughly 2.5% while fixed investment expenditure will be held back by poor confidence levels that undermine private sector capital expenditure.

Consumer spending over the next year will be depressed by slow employment growth and tighter credit conditions. Weaker consumer demand and imports will partially offset lower commodity-related exports to China and help to bring the current account deficit down. But the deficit remains wide and puts the exchange rate at risk from foreign portfolio outflows.

On domestic equities, van der Merwe said: “The market is expensive with the all share index trading at a historic price-to-earnings multiple of 19. While companies have maintained earnings growth and consensus expectations are strong, there is a limited margin of safety.