Johnson & Johnson on a dividend yield of 3.7% ,US Treasuries yie

Risk on or risk off?


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Thank the macro managers for the opportunity for equity return.
For some time, correlations between financial assets have been extraordinarily high. Tick by tick, currencies, commodities, stocks and bonds appear to be driven by the same forces. On any given day, if you know what has happened to euro-yen you will have a good feel for what will have happened to the Nikkei, Treasuries and gold. Likewise, if copper is up, stock markets are likely up.

To an extent this can be explained by the globalized nature of financial markets. Capital is generally free to move to wherever the return is best, or as has been the case more recently, the risk is lowest. But, a strong argument can be made that markets appear to be heavily influenced by money managers that are switching between asset classes based on a top down or macro view of the world. Witness the incredibly sharp moves on equity markets in recent months. Global equities were full of the joys of spring in April of this year after a remarkable twelve month rally. Then, the second quarter of 2010 was torrid with declines of between 10% and 20% the order of the day for global stock indices. Since, we have seen the market rally sharply in July, only to succumb to aggressive profit taking over the past week.

For financial markets, it appears to be either risk on or risk off. The collapse of 2008 was followed by an euphoric economic recovery of 2009, which has given way to extreme concern over the outlook for global growth. Many commentators are predicting double dip recession or at worst Japanese-style deflation in the West. Consensus growth forecasts are being slashed as concerns mount over persistent weakness in the job market, the lack of improvement in US housing and a clear slow down in China. The market is clearly very nervous at the moment and confidence is low.

Nobody should be arguing that the risks facing global financial markets are not immense and that a deflationary outcome is not outside the realms of possibility. But, we find it particularly noticeable how many pundits are currently forecasting a particularly bearish outcome for equities, based on their very bearish view on the economic situation. Equity markets may well be in for a tough time at a headline level, however, we think it quite likely that carefully selected stocks will perform surprisingly well over the next few years. And, it is this current obsession with a macro interpretation of the global economic forces and an over-simplification of the impact on equities that gives rise to this opportunity.

Recent price action on financial markets indicates that investors have become decidedly bearish on economic growth in the West and China, but remain steadfastly bullish on growth in most other emerging markets.

It is clear that investors in US Treasuries yielding less than 2.7% are taking a dim view on growth and are very comfortable that inflationary pressures are not on the radar screen. If a deflationary spiral is forthcoming, treasuries may yet provide real yields, but for anything other than this outcome they look like they are horrendously overpriced. By example, you can buy Johnson & Johnson on a dividend yield of 3.7% The fact that the dividend of this US blue chip company, with more than half of its earnings generated in countries other than the US, yields more than a 'risk-free' bond, implies that the market is pricing in a sharp decline in earnings over the years ahead. If the stock were to actually grow its earnings over the next decade, which after all is the most likely result, the return from this stock will exceed the return that a bond generates by a mile. In essence, you are buying a relatively cheap option that the world does not fall in a heap. Also, remember that low inflation, a supportive valuation, a strong balance sheet and reasonable profit growth is an environment for attractive returns from a stock.

Similarly, on the JSE, whilst many stocks look to us like they are priced for a very rosy earnings outcome, and here we would make special reference to the 'flavour of the month' industrial shares, we can find some stocks that should provide attractive returns in any situation other than a collapse in earnings. We have stocks in our portfolios that are trading on normalized earnings yields of above 10%. South African ten-year bonds are yielding just above 8%. If a stock with an earnings yield of 10% to 12% manages to grow its earnings, returns will be attractive, particularly relative to the so-called 'safe havens'. Real yields on domestic bonds look decidedly unattractive in any situation other than a very benign inflationary cycle given the structural pressures on inflation in South Africa.

The current scare on the global front is deflation. Given the likelihood of co-ordinated central bank attention on staving off deflationary pressures, the real concern over the long run could well be inflation, and in its most dangerous form stagflation (or inflation without growth). In a world in which inflation could become the primary concern over the long run, one of the asset classes of choice will be cheapish equities; especially those that have pricing power and hence can grow profits ahead of inflation and pay attractive dividends.

We don't know what the global economy holds in store for us and we are also cautious at a macro level. We also don't know whether authorities will succeed in their quest to restore confidence in financial markets. And, it is almost impossible to make predictions on the outcome for equity markets at an index level. But, we do know that some shares are starting to price in a very negative profit outcome. The pay-off if this is not the case will be good.