Not time zero yet… still some ‘green shoot’ cynics

Chris Freund, portfolio manager at Investec Asset Management, believes we are reaching the end of the ‘sweet spot’ in equities, but is confident that latecomers should still see inflation-beating returns over both the medium and longer term

There is nothing irrational or mysterious about the way the SA equity market has behaved, rallying 38% since its lows in March. The equity market is a forward-looking discounting machine, and has been pricing in the improving global growth prospects into 2010. In this instance, as in almost every other past recession, the stock market starts to improve rapidly once there is reasonable certainty that the rate of economic decline is starting to slow. At this point the market starts to price in improving prospects in the future, and historically this part of the equity cycle has offered the highest returns.

The question now is whether there is anything left for latecomers into the equity market. We believe there may still be some legs left to this rally, as we have not quite yet reached ‘time zero’ yet. ‘Time zero’ is that point in the cycle at which the last cynics throw in the towel and accept that the global recession is officially over and that the economy is growing again. Until then, we should continue to see a barrage of positive economic data that supports the view that a global economic recovery is underway. Low interest rates will start having a positive impact on the global economy and government-induced excess liquidity will also provide a boost to equity markets.

And only once the last of the “green shoot” doubters have taken their equity weightings back to neutral from underweight positions, is the rally likely to lose steam. Markets should then start trading sideways. Since stock markets at that point would already have priced in the recovery, they are then likely to wait for the earnings which they have discounted to actually come through. The good news is that this point is only likely to be reached in three to six months’ time, when the expected strong third and fourth quarter US GDP growth rates of 4% to 5% emerge.

Once we enter this sideways equity phase, stock-picking will be critical. No longer will a rising tide lift all equity boats. Markets are likely to be volatile, driven more by individual company announcements as opposed to at present by the improving macro economic picture. Clear sectoral themes, such as the recent “recovery trade”, are unlikely to dominate as they have recently. The sideways, choppy phase will probably last for two to three quarters, after which we should see equity markets start rising again as earnings growth begins to improve.

Unfortunately, don’t expect the gains to be quite as spectacular as the current rally. This is because policy makers – once they are convinced that economic growth has taken hold – will have to start raising interest rates from their abnormally low levels. Stock markets hate higher interest rates, so over the next six to twelve months we will see the traditional tension that develops in financial markets between the positive effects of rising earnings and negative effects of rising interest rates.

In conclusion, even though the earnings versus interest rates conflict will temper stock market performance, equities remain a good bet for inflation-beating returns over the longer term. We do not subscribe to the view that the recent rally has been dangerously induced by unsustainable economic policies that will only end in another round of tears. What we have seen is the deflation of credit and property bubbles around the world, which if nothing else should make for a safer albeit lower growth long-term investment environment.