Global equities continue to ride high on profit wave
The main risk to the current unprecedented high levels of global profits would be a sharp slowdown in global economies an event very unlikely to occur anytime soon, according to Eric Lonergan from Prudentials London-based asset allocation team.
Speaking at a recent Prudential Portfolio Manager investment conference in Johannesburg, Lonergan comforted nervous equity investors saying that while current levels of profits are at a historic high, conditions that could result in a sudden erosion of profit share are simply not in place.
"PE multiples are not elevated and any sudden reduction in profits as companies go on major capital expenditure initiatives is unlikely. Yet global equity markets are currently offering incredible value, because investors have short time horizons and overreact far too easily to short bursts of volatility."
Lonergan says equity markets currently offer good opportunities for investors willing to take a medium term view and tough enough to withstand the emotional challenges posed by short-term price volatilities.
"South African equities are a very good example of where value is available for the global investor and prospective returns are likely to reward rather than disappoint."
According to Lonergan equity markets are currently paying investors a high risk premium, because the popular view is that since earnings have surprised on the upside for so long that a mean reversion must be on the horizon.
But he maintains that investors are simply slow in coming to terms with a changed global environment.
"We now live in a world where levels of profitability can be very high. Elevated levels of return on capital can be sustained, because structural characteristics of the global economy are very favourable to earnings.
"We have, for example, seen an approximate doubling in the global supply of labour in recent years, as first Eastern Europe and then China and India integrated into the world economy. The result of this is that wage pressures have been very subdued, thereby upping the return on capital."
Graham Mason, CEO of Prudential Portfolio Managers in South Africa, agrees. He says the strong earnings trend has not only been noticed worldwide, but also in South Africa.
He says that South African earnings over the past three years have consistently surprised on the upside with the result that, for the first time, local analysts keep on having to upgrade their earnings forecasts.
Mason says until about 2004 earnings constantly disappointed, forcing analysts to issue downgrade after downgrade. However, in recent years this trend changed and earnings upgrades are now the norm rather than the exception.
According to Mason margin expansions both locally and worldwide are responsible for the dramatic increases in company earnings.
"With margins in South Africa the highest since the 50s and 60s, it is not surprising that earnings have followed suit. The local environment of strong commodity prices, rising infrastructure spend and ongoing consumer spending is very supportive of substantial margins."
"Profitability increases with margins. Our belief is that globally high levels of profitability are as a result of increased global labour supply and heightened microeconomic efficiency."
Mason agrees with Lonergan that the key drivers of earnings growth are here to stay, both globally and in South Africa. Therefore, he says, corporate profits are likely to continue outpacing share prices, resulting in a stock market that continues to offer value.
Lonergan notes that globally there is also no evidence of an inflation problem. In fact, he comments, global economies are continuously improving their efficiencies and as a result the core inflation rates in the OECD area are now consistently below 2%.
"Don't forget that the global economy is extremely well diversified the European economy remains strong, together with the US, China and others. In summary, the structural characteristics of the global economy are very favourable for equities."
