Equities: Emerging from the shadows

Andrew Cole, Senior Investment Manager, Multi Asset, Pictet Asset Management

The global economic upswing has now lasted longer than a typical recovery (if there is such a thing). However, we think it would be wrong to look for another recession around the corner. Crucially, the rate of economic growth has been subpar, which means there is still plenty of room left for expansion.

That is particularly apparent when we look at the progress of corporate profits. In most parts of the world – including the UK and the euro zone – earnings remain some way below their previous peak. Even in the United States, where the recovery has been more pronounced, earnings have only just about reached their long-term growth rate.We therefore expect that the slow-yet-steady economic and earnings recovery will continue through the rest of this year, into 2018 and beyond. However, another common trend of the recent past is running out of steam – namely the outperformance of bonds over equities.Most investors have – in some shape or form – benefited as bonds persistently delivered an equitylike return with significantly less risk, basking in the glow of undershooting inflation expectation and generous central bank quantitative easing policies.One of the consequences of this is that investors have forgotten how much risk, on average, one needs to take to achieve the kind of returns traditionally associated with equities. Markets are about to remind them.When you look at today’s pricing of bonds, you see that much of the world offers a negative real yield. That is true not just for government debt, but also for investment grade credit, where below inflation yields are becoming increasingly common. So, without further capital gains from falling yields or credit spreads (which we do not expect), bond returns look set to be negative in real terms and certainly a long way short of what investors have experienced over the last decade.Of course for many investors – insurers, pension funds and the like – there has been an increase in regulatory pressure to lower their risk profile. That potential demand is likely to put a floor under the bond market. So while bonds are expensive, the chances of picking them up cheaply in the foreseeable future look pretty low.Equities, in contrast, offer the prospect of exposure to continued earnings growth as the breadth and depth of the global economic upswing develops. Furthermore, for investors looking for an income stream, global stocks offer a dividend yield of a respectable 2.5% – nearly double the yield of global government bonds.1We do not believe the global economy works to a calendar. Therefore, whilst this expansion has undoubtedly been longer than most, it continues to be supported by central bank stimulus – in the first half of this year, alone, they have printed around US$2trn of fresh money. We do not see any serious inflationary threats on the horizon that would motivate central banks to tighten monetary policy aggressively. Indeed, this summer has once again witnessed a period of falling inflation expectations and a corresponding lowering of forecast for interest rate rises.Additionally, electoral forces are pushing governments around the world to retreat from the policies of austerity towards more stimulating fiscal policy. This, to our mind, suggests that a recession is still some way off. Latest Purchasing Managers’ Index (PMI) data from the US and the euro zone supports this view, and our own business cycle indicators also signal economic resilience.That being the case, we see a number of years of earnings growth ahead of us to the benefit of the equity investor. Europe, including the UK, has particularly attractive prospects in this area as it is around two to three years behind the US on the recovery path.Our analysis suggests that the equity risk premium is above its historical average. If bonds remain expensive and continue to offer negative real returns, we expect that investors who seek positive real returns will increasingly look towards equities to provide that growth. And that will mean accepting the perceived increase in risk for doing so.  1) JP Morgan GBI, August 2017