– Chuck Prince, CEO of Citigroup, July 2007.
- We are witnessing a synchronized slowdown worldwide that is beginning to affect corporate profits.
- The most likely right-tail event is the Federal Reserve launching another round of quantitative easing.
- We don’t believe liquidity alone can engineer sustainable, real economic growth in the context of a secular deleveraging cycle. But we acknowledge that equity portfolios would likely benefit should the Fed keep the music playing a little longer.
This infamous quote from the then-CEO of Citigroup appropriately outraged many people because it suggested that large banks knew their actions leading up to the financial crisis were risky, but they lacked self-discipline. They felt compelled to continue to increase risk to try to drive their stock prices higher. They said they hoped regulators would restrain the market as a whole, so no one bank could be criticized for excessive caution. They sought short-term gratification even if they had doubts about the long-term effectiveness of such risk-taking.
Thanks Be To QE
Today equity investors are facing a similar situation. As I discussed in my prior Equity Focus, “Three Years and Counting,” equity investors have enjoyed strong returns over the past three years due in part to the Federal Reserve’s massive monetary intervention via its quantitative easing programs -- QE1, QE2 and Operation Twist. While QEs have made some headline economic data temporarily look better and pushed asset prices higher, we at PIMCO don’t believe liquidity alone can engineer sustainable, real economic growth in the context of a secular deleveraging cycle. In fact, we believe there are costs and risks associated with such easy money, and Federal Reserve Chairman Bernanke has acknowledged some of those unintended consequences. As taxpayers and citizens of the global economy, we fear that the costs and risks from further quantitative easing could outweigh the benefits, and it will not, by itself, lead to sustainable growth. But as investors working to help our clients meet their investment objectives, we acknowledge that equity portfolios would likely benefit should the Fed keep the music playing a little longer.
While we believe the long-term outlook for equities remains attractive, the short-term outlook today is mixed. Price-to-earnings multiples appear reasonable on a historical basis -- 14 times for the MSCI-World Index and 11 times for the MSCI-Emerging Markets Index – but the outlook for earnings is now more muted than it was a few months ago.
In my April Equity Focus, “Newtonian Profits,”I highlighted five factors that could cause strong corporate margins to mean revert:
- Cost of labor increasing
- Economic slowdown or recession
- Dollar strengthening
- Cost of capital increasing, or
- Corporate taxes increasing
Since that time three of those factors have remained favorable for equities, while two have weakened: The global economy has slowed substantially, and the dollar has strengthened as growth in other regions has slowed. We are witnessing a synchronized slowdown worldwide: Most economic data in the U.S. have disappointed in the past couple of months. Europe continues to be consumed by its sovereign debt challenges, which are severely damaging economic growth around the region. And China has slowed meaningfully from its breakneck pace of the past few years, though we continue to believe China will avoid a hard landing.
This global slowdown is now beginning to affect corporate profits. As the more moderate economic data came in, investors and analysts took down their earnings estimates. Now that earnings season is underway, we have seen approximately 60% of the companies that have reported earnings through July 24 beat these lowered forecasts. In general, corporate profits have come down, but not as far down as people expected.So, what is our outlook for stocks now? Reasonable valuations in a longer-term context with some near-term pressure on still-strong corporate earnings suggest the potential for treading water or potential near-term weakness in equity returns, barring any left-tail or right-tail shocks.
Potential Shocks
But it is important that we spend time reviewing those potential positive and negative shocks, because the tails are likely to dominate the mean and determine what equity investors actually experience in the next year or two.As my PIMCO colleagues and I have commented on repeatedly, major downside risks remain from 1) the ongoing sovereign debt situation in Europe, which will likely take years to resolve but could destabilize at many points along the way, and 2) political dysfunction in Washington related to the so-called fiscal cliff. A disorderly unraveling of the eurozone would almost certainly push the global economy into a serious recession. And if the fiscal cliff were to occur, it would likely trigger a recession in America, given slow underlying growth of only 1% to 2% before the cliff. Either of these events could cause stock prices to fall meaningfully.
On the positive side, the most likely right-tail event is the Federal Reserve launching another round of quantitative easing, or QE3. As noted above, most U.S. economic data of the past couple months have come in below expectations, a clear indication the U.S. economy is slowing. In his testimony before Congress, Chairman Bernanke acknowledged the recent weakness: “Economic activity appears to have decelerated somewhat during the first half of this year.” Unemployment remains unacceptably high at 8.2%, and the Federal Open Market Committee expects inflation to be between 1.2% and 1.7% this year, below its target of 2%. In effect the Federal Reserve is missing on both of its mandates with unemployment too high and inflation too low, which Chairman Bernanke acknowledged: “It’s very important that we see sustained progress in the labor market and avoid deflation risk.” Meanwhile, the rest of the global economy is weakening. All these factors suggest the Fed is more likely than not to launch a new round of quantitative easing.
Cost Of Borrowing
Corporate and consumer borrowing costs are already near record lows. While a massive QE3 could bring them down somewhat further, it isn’t clear how much of an effect this would have on corporate or consumer behavior and hence real economic growth. Well-qualified homebuyers can get a 30-year fixed-rate mortgage today for about 3.5%. It is unlikely there are many buyers on the sidelines waiting for rates to drop even lower. More liquidity does have to go somewhere, however, and to date, with each expansion of the Fed’s balance sheet, it appears to have gone into risk markets, pushing prices higher -- without necessarily changing underlying economic fundamentals. Hence we believe a new round of quantitative easing would push stock prices higher yet, tipping the balance of risks for equity investors to the positive.
My comments thus far have focused on the outlook for equities as an asset class, with both left- and right-tail risks. But our active equity strategies aren’t investing in the market as a whole. In this muted return environment that will likely be dominated by the tails, we believe individual stock selection is critical. We continue to buy equities today -- equities we believe will do well in this slowing economic environment or those we believe will be more resilient against the shocks we see.
Stock Picks
In a slow-growth economic environment in the U.S., we like companies that consumers turn to in order to save money. We like companies selling products people need to buy even if the economy weakens. And we like companies selling into higher-growth markets.
In Europe we see that the stock prices of many companies are being punished because they are headquartered or listed in the eurozone region. But not all of those companies are at high risk from Europe's debt woes. Some are in sectors selling goods people will likely need to buy regardless of the economic outlook, such as pharmaceuticals. Some companies happen to be headquartered in Europe but earn a majority of their sales in more stable export markets.
In the emerging markets we tend to favor global leaders with strong management teams, strong balance sheets and market power.We continue to believe macro views are critical to understanding overall risks, while bottom-up views are critical to selecting the companies that are likely to do well in various economic environments.
And Then There Was Inflation
It is ironic that equity investors need the Federal Reserve to act to tip the scales to make equities more compelling in the short term, because it is the Fed’s own actions to date that are forcing investors to invest in equities over the long term. As I discussed in “Three Years and Counting,” in the long term we may face higher inflation due to both the deficit overhang of developed economies and central banks’ aggressive monetary policies. Such an inflationary scenario means that investors will need to remain invested in equities and real assets in an effort to protect their purchasing power and meet future liabilities. We don’t know exactly when these inflationary pressures will take hold in the economy, so for those investors who can tolerate equity market volatility, we believe remaining invested in higher-quality stocks is the right approach.
These markets remain highly dependent on policymakers: We need policymakers to avoid the major downside risks that could tip the global economy into recession. And while we have concerns about risks and unintended consequences of further quantitative easing, we believe such monetary stimulus would continue to push up the prices of risk assets and equities in particular. Equity investors would likely benefit from one more dance -- though the QE party can’t go on forever.