‘Dollar bears, China bores and the V-shaped recovery that no-one is predicting’

A good story has always gone a long way in the stock market. Expensive valuations can endure if the market has conviction in a compelling growth narrative. Equally, cheap assets are often neglected through the lack of “catalysts”. Moreover, once “belief” in a story is established it is often difficult to shift even when fundamentals begin to change. Currently, the highest conviction “beliefs” in the market are that: i) the economic recovery will be anything other than “V”-shaped; ii) Emerging Markets, or specifically China, will continue to outpace the developed world in economic growth and stock market returns; and iii) the US dollar will continue to weaken. We are often asked how our views differ from consensus. Well, all three of these widely held views look like stale narratives to us. We have had enough of dollar bears and China bores, and sense that the economic recovery is shaping suspiciously like a “V”. We are often asked what the “story” is for European equities. Our answer is that there is no compelling secular growth narrative for Europe. That is Europe’s strongest point.

We hear every day from someone about the likelihood of a non-“V”- shaped economic recovery. After all, although every economic downturn sees companies curtailing production and cancelling orders, this one has been almost unprecedented in its severity with large double digit collapses in industrial production in most major economies. However, the neglected story is that real demand for most goods has suffered only a fairly routine fall-off (see Chart 1). This has meant that inventories in many industries have been drawn down to an unprecedented degree. With very low inventory levels any normalisation in demand levels, caused by pent-up demand and easier credit, is likely to be an equally powerful positive stimulus to production. This is how the recovery could be “V”-shaped after all.

Equally Purchasing Managers Indices give a good idea not only of future economic activity – hence their strong predictive power of industrial production – but of why economies tend to recover from slumps. Managers are asked whether monthly conditions are getting better or getting worse. If conditions are no longer getting any worse, then by definition they get better. This is why PMIs tend to revert to equilibrium levels. For most Purchasing Managers business conditions won’t get any worse than December 2008 and it will not be long before the majority are experiencing less bad (i.e. better) conditions. Global PMI’s are moving back towards equilibrium (Chart 2). This means economic expansion and the end of recession. Most major economies will return to growth in the second half of 2009. This recession is ending like all of the others, in a recovery that is suspiciously “V”-shaped.

This bottoming out of economies should also mark the low-point in corporate profitability. Earnings are currently still being downgraded by analysts, although the pace of downgrades has recently slowed quite dramatically. Importantly, the earnings downgrade process over the last 18 months has already brought earnings forecasts for European equities down by 50%, which will have been the biggest profit recession in recent memory (Chart 3). From a level of corporate profitability that looked unsustainably high in 2007, European companies are now under-earning relative to their history (lower profit margins on expanded equity bases) with a forecast return on shareholders equity of 10% relative to peak profitability of 17% and a long-run average of 12%. If we are correct about the strength of the economic recovery, the current second quarter earnings season is likely to be the last to see net downgrades. When we buy equities today it is increasingly likely that we are buying trough earnings i.e. companies which are under-earning, where we can expect an earnings rebound on a normalisation of economic activity.

Although the European stock market is already up 30% in local currencies since March, this needs to be put into wider perspective. The overall market level is still down almost 50% from its peak and back to levels seen in 1997 (and briefly 2003). In other words, the last 12 years have been a “lost decade” for equity returns despite significant progress made by most companies in terms of sales and profits. This is best articulated by the Graham & Dodd European P/E (Chart 4) which divides today’s price by the average of the last 10 years’ earnings, which shows a P/E of 11x, a 45% discount to the long-run ex-bubble average of 20x. Moreover, on profit estimates that have already been halved, the forward P/E is back to levels last seen in the early-80’s and mid-70s when inflation and the risk-free rate (and therefore the cost of equity) was significantly higher than it is today. Buying a share of European corporate profits when companies are under-earning, the profit cycle is about to turn upwards and when valuations are at multi-decade lows would appear to be a once in a generation investment opportunity. Only an event as debilitating as the credit crunch could have caused this.

The fundamental attractions for European equities appear to be on the turn. They remain, however, the least favourite geographical subsector of the most unpopular asset class, and have seen small net redemptions year-to-date and indeed net outflows over the last 10 years. This undoubtedly has much to do with the distinct absence of a good “story”. The secular growth narratives of Chinese industrialisation, commodities, infrastructure and agriculture are wellknown and continue to endure. Yet stock-market history suggests that bear-markets only truly end when “belief” in secular growth narratives has been shattered and that new bull markets form in sectors previously denied capital and which did not participate in the previous bull-run (Chart 5). In other words, sector leadership tends to change from one bull market to the next and previous leaders often turn into laggards.

With (according to recent surveys) investor enthusiasm for all things Chinese at an all time high, it seems almost heretical to challenge Chinese stock market hegemony. Yet it seems somewhat at odds with this secular growth narrative that China has been the recipient of the biggest fiscal and monetary stimulus: its government is spending $266bn or 6.1% GDP and its banks are increasing lending by 30% year-on-year (Chart 6). Economies where money supply (M2) is increasing at rates of more than 25% don’t normally have happy endings. With over-capacity in most Chinese industries, there are already signs that this stimulus is leading to a speculative bubble in property and stockpiling of commodities such as copper and iron ore. It is also difficult to see how Chinese infrastructure spend can do anything other than decelerate from its current 50% year-on-year growth rate, particularly as infrastructure spend by local governments away from the prosperous Eastern Seaboard (where there is more potential for new projects) is now significantly in excess of local tax revenues. It has been fun, but China is unlikely to give us a positive surprise from here.

In addition, the correlation between Emerging Market equities, commodities and a weak US dollar is particularly high, which suggesting they are all part of the same successful decade-long trade. But the well-worn arguments for dollar weakness now seem stale. The US trade deficit has already come down from 6.5% of GDP in 2005 to just over 2% currently; the US personal savings rate has recovered from a negative figure to nearly 5% of disposable income; the greenback looks inexpensive relative to its history and to measures of purchasing power parity and the expensive foreign policy mistake of the Iraqi war is drawing to a close. US housing now looks cheap, with the median US house price to median family income ratio now down to 2.8x compared to a peak of 4.1x in 2005 (Chart 7). When the US economy bottoms the greenback usually rallies. Bets that rely on a permanently weak dollar look a bit passé.

On the other hand investors seem to have forgotten the relative size and influence of the US economy. Looking at economic data series in the US it is impossible not to be struck by just how bad the current data is relative to history, to conclude that in all probability the data can only improve from here and to be excited by this recovery potential. New car sales are back to 1981 levels in absolute terms and per head of population back to where they were in 1961. New home sales are down 80% since 2005. Consumer confidence is bouncing from its worst ever levels. Initial jobless claims approaching 700k per week have been seen just once before (in 1981) since the data set began (Chart 8). The end of recession and a normalisation of the US economy will be a huge delta for the global economy and in particular for European businesses with significant North American exposure. European companies and sectors with a high level of exposure to the US have generally been stock-market laggards over the last decade. The weakness of the dollar against the Euro has been a significant drag on the European economy. The wind may be changing direction.

“Recovery” from severe recession rather than “secular growth” is now the main stock market opportunity. Given lowly valuations, there is no need for seductive stories to dress the opportunity up as secular growth. Recovery involves buying assets that have been priced for failure or at least for a continuation of current poor trading into perpetuity. When economic conditions normalise, the investor usually makes money. Although it is a natural human emotion to stick with stock-market growth narratives that have worked well recently and appear largely un-contentious, greater returns at stock-market inflection points fall to those willing to be contrarian. When one adds the historic status of the European stock market as the high-beta play on US economic recovery to multi-decade low valuations, a turn for the better in the earnings cycle and sentiment towards an asset class that can only improve, it may prove difficult to find a better time than now to invest in European equities. If not now, then when?

Barry Norris
Partner, Argonaut Capital, July 2009