Five reasons to be positive about international shares
Perpetual Investment's Brigette Leckie explains why you should be feeling a little more optimistic about international shares at present
Tuesday, June 24th 2003, 9:55PM
As investors heave a sigh of relief following the recent 20% bounce in international shares, the question now is whether the rally is sustainable, or whether it’s just another bear market bounce.
I expect the former is the case but caution those who anticipate a return to the pre-tech euphoria of the late 1990s.
Below I’ve outlined five reasons why you should be feeling a little more optimistic about international shares at present, particularly those in the US and Asia.
1) The US economy is gaining momentum
For those that missed it, the US economy has already recovered from recession. Last year it grew by 3.0%, and is predicted to grow by a similar margin over the first half of 2003. Any sort of growth is good for shares. Importantly, US growth should build momentum over the coming six months to somewhere close to trend (around 3.25% to 3.5% on an annualised basis).
Supporting the US economy at present is a combination of the low interest rate environment (at 40 year lows), and President Bush’s US$350 billion tax package.
In addition, the US household sector continues to be robust, and in many ways is positioned for growth. Declines in interest rates and mortgage refinancing have enabled the household debt servicing burden (required debt and interest payments as a proportion of income) to decline over the past year. What’s more, households have endured a period of declining employment and much higher energy prices without significant downside pressure on the savings rate.
For the corporate sector, significant progress has been made in working off the excess debt that was taken on during the tech boom years. As a result, corporates will most likely be looking to boost their capital expenditure over the months ahead. With capital spending well below depreciation, much of the pick up will reflect a need to modernise and update rather than expand and increase capacity.
Another major driver of the US economy in coming months should be the weaker US$. From this vantage point it seems we are in the midst of a choreographed depreciation of the US$. By omission, both President Bush and US Treasury Secretary John Snow make it clear they are not going to recommend any action to stop the dollar from falling.
This is a net positive for international shares, as a strong US sharemarket and economy should provide impetus for the rest of the world, so long as the depreciation is controlled. This seems to be the case at present. A weaker US$ boosts the profits of exporters and removes concerns that the US economy may be tempered by the possibility of deflation.
2) US profits to surprise on the strong side.
While US profits turned positive on a year on year basis in June 2002 (+5%), they were still below the market’s expectations which were predicting an increase in profits of around 20%. The predictions are becoming more realistic this year, with consensus forecasts looking to a rise in US corporate earnings of 13%. This is a number that should be easily met, and most likely exceeded. Supporting US profits should be further improvements in productivity which have the double effect of increasing profits and making companies more leveraged to a rebound in revenues.
Additionally, the gap between reported profits and operating profits has narrowed dramatically as write-downs have slowed. Undoubtedly, US balance sheets are a lot healthier. The change in focus to shareholders' returns is also reflected by the falling capital expenditure to sales ratio of the S&P500, which is now 6.80%, compared to its peak in 2000 of 9.4% and long-term average (20 year) of 8.20%. In addition, the cash to market cap of companies in the S&P500 currently sits around 9.0%, compared to the long-term average of 6.8%.
3) Confidence has rebounded
The emphatic victory by the coalition in Iraq has boosted investor sentiment. This has resulted in a reduction in risk aversion by investors, reflected by improving consumer and business confidence reports in the US and declining corporate bond spreads. In fact, since October 2002, US corporate spreads have narrowed from 260 basis points to 80 basis points. The other positive for equity investors as a result of the resolution of the conflict resolution is the price of oil. West Texas Crude has dropped 40% from its highs, and the result is that consumers have more to spend on discretionary items, such as a new fridge or computer.
4) Valuations are reasonable
Valuations are less of a constraint for international shares. On a price/earnings basis, the US sharemarket has returned to its long-term average taking into consideration the fact that we are in a low inflation environment. The US sharemarket, as at the end of May, was trading on a forward P/E (ie: 2004 financial year) of 19.6 times compared to its long-term historical average of 15.5, but the low inflation and low interest rate environment does support higher P/E’s.
On a relative basis, international equities offer exceptional value, with major bond markets at historic highs to equities. Indeed, the yield of the UK market is close to that of its ten year bond yields. The relative valuation gap is also apparent if you compare some equity markets to property markets, where in many countries annualised rents as a percentage of house prices (3 bdrm) is now below the dividend yield. This is currently the case in Australia.
5) The technicals are supportive
On several technical criteria, the recent rally has strong foundations. For the first time in this bear market, this rally began from a higher trough than that of the last market correction - 800 points on March 11, compared with 776 points on October 9. The rally so far has also taken out the last market high in November and most recently the previous high in August. This indicates that the downward trend in prices is abating. Another positive technical indicator is that "trend resistance" -a line linking previous market peaks during the downtrend in prices- has been broken. The rally has also broken the 200 day moving average in prices.
What’s more, the current rally in the US has coincided with rising volumes and broad based gains across all industry sectors. This has not been the case in past rally attempts, and indicates greater conviction on behalf of investors.
What can investors expect?
The sharemarket recovery so far has been swift and one directional. But don’t expect this to be the case over the next 12 months. This recovery will most likely take a ‘two steps forward, one step back’ approach, as investors continue to question the strength and sustainability of the economic and profit recovery.
Importantly, there are still a number of factors that are weighing on global sharemarkets. First, there are a number of imbalances within the US economy, including excess capacity in some areas of the market -a hangover of the “irrational exuberance” of the late 1990s. This will continue to pressurise companies’ ability to raise prices as they continue to compete on price.
Other factors weighing on the market include the relatively low savings rate in the US and abroad, and the possibility of further terrorist attacks which, among other things, would send oil prices higher and pressurise consumer confidence. Europe also has some problems at present, particularly structural issues surrounding companies’ ability to shed staff, the rising euro and the speculation that Germany is suffering from deflation.
The US, on the other hand, has shown that its economy can bounce back from economic slowdown very quickly, helped by its pro-active fiscal and monetary stimulus policies and flexible industrial relations policies. As a result, US stocks are well placed to deliver high single digit returns, especially if you look 12 months out. And any recovery in the US is good news for Asian companies which ride on the coat tails of the US (usually with a six month lag).
Finally, let us put things into perspective. While high double digit returns from hereon in are unlikely, investors can look forward to better times ahead from international shares, especially from the US and Asia. Most importantly, this upturn is built on the strong foundation of fundamentals, not the unsupported pillars of speculation.
Brigette Leckie is the head of investment market research at Perpetual Investments.
Disclaimer: This information is not intended to provide advice to particular investors, or to take into account an individual's investment objectives, circumstances and needs for investment. Investors should consult a financial adviser. This information was provided by perpetual Investment management Ltd (ABN 18000 666 535). To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.
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