During the course of our recent client meetings, we have highlighted the risk of a ‘pull back’ in equity markets in the near term, if only because of the unusually strong rallies since the lows in March 2009. Sadly, the catalyst for such a pullback was not what anyone would have wished for. The dreadful events that started to unfold from late Friday in northern Japan was clearly the ‘straw that broke the camel’s back’ after a series of events that have been building up (but largely ignored) by the market over the last few weeks. These include the continuing unrest in the Middle East, the civil war in Libya, rising oil prices, inflation and further uncertainty surrounding the debt crisis in Europe.
Just three weeks ago, the S&P 500 was at 1344 with the biggest year-to-date gain in 13 years of 6.8%! By today (16th March) it was up a mere 1.9% after a brief fall into negative territory during US trading hours. Volatility has surged as fears over Japan’s economy rocked international markets. But the key question is “to what degree does this risk derailing the global economic recovery?” In short, not much. Japan accounts for approximately 8.7% of global GDP compared to 25% for the US. As tragic as the events in Japan are, it is only likely to dent Japanese growth for a few months (estimates of between 0.2% to 0.5% of GDP) and they are likely to see a strong rebound as the country rebuilds. Indeed, this is the typical pattern one sees after natural disasters such as Hurricane Katrina in September 2005. Clearly, one difference is the nuclear crisis surrounding this earthquake which does add an unknown extra element to the economic impact.
However, this week, the OECD released their March leading indicators (CLI’s) for Germany, Japan and the United States all of which point to robust expansion relative to trend. Even France and Canada have regained momentum and the UK points to slow and stable expansion. In contrast, China’s CLI is pointing to a moderate downturn as does India’s. This confirms our belief that the global economy continues on a recovery tack for some considerable time and the events in Japan will not have wider implications.
Whilst we believe that the rate of expansion is set to slow over the coming months and it likely that newspaper headlines will suggest that the global recovery is over, we do not believe this will be the case. As long as the leading indicators stay above 50 (expansionary), economies will continue to prosper. From a stockmarket perspective what one does see, is sector rotation. But markets will continue to grind higher over the long run.
It is notable that the record earnings we have recently seen in the US and UK has been fuelled by the highest profit margins since 1993. This is giving company boards more leeway than ever to boost dividends as the market rebound enters its third year. S&P 500 profits will rise 16% this year and surpass $100 a share for the first time in 2012, helping persuade executives to boost payouts. Indeed, American companies increased stock buybacks in 2010, making it the fifth-biggest year for share repurchases since at least 1985.
Non financial company margins will climb to nearly 9% in 2011, the highest level in at least 18 years. Whilst there is the possibility that these will ease back as commodity price increases start to bite and employment starts to pick up, we do not believe this is a negative, merely a cost of doing business as the expansion gathers momentum.