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Experienced Investor

Three reasons to be overweight equities

Kerry Craig
Written By:
Kerry Craig
Posted:
Updated:
10/12/2014

Risk can be a highly personal concept for investors, one that largely hinges on time horizon and tolerance for volatility.

Even so, as we approach the second half of the year it doesn’t hurt to take an objective look at some of the biggest risks investors are likely to face. So, how do we read the runes while still minding the risks?

First the good news. The eurozone is in an extended period of relative calm. In the US, headwinds such as the “fiscal drag” have cleared and economic growth should build throughout the year, leaving the weather-distorted first quarter just a chilling memory. Meanwhile, UK growth has been so strong that the Bank of England is bracing households and businesses for earlier-than-expected interest rates rises.

However, while risks in the macroeconomic environment have ebbed significantly, we cannot discount the more nuanced risks-such as investor complacency and questions about the current low levels of volatility-that remain. At this point in the economic cycle, low volatility is not unusual, but investors should bear in mind that this climate will not last forever. More volatility may be introduced into markets as central banks go about the process of “normalising” yields.

In our view, maintaining a cautious overweight to equities is justified for three simple reasons. First, monetary policy remains highly accommodative, despite continued talk about rising interest rates.

As shown in the charts below, central banks across the developed world slashed policy rates in order to tackle sub-trend economic growth. This aspiration is not going to change in the short-term. The European Central Bank has further eased monetary policy and more action may be on the way this year. Meanwhile, the Bank of Japan is expected to double the size of assets on its balance sheet relative to GDP as it continues with its quantitative easing programme.

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All of these policies are designed to stimulate the economy by getting investors to move into riskier assets. Low interest rates are a positive for stocks because they both increase the present value of future earnings and reduce the attractiveness of alternative assets, such as cash and bonds. They also have the benefit of lowering interest expenses for the corporate sector, which has traditionally been a net borrower.

Interest rates will eventually have to rise. But the tightening of monetary policy should be a gradual process, and the path of interest rates will be steady enough to remain supportive of equity markets. Historically, raising interest rates from very low levels doesn’t tend to hurt the stock market because such moves are indicative of a strengthening economy rather than an overheating one.

A second reason to be cautiously overweight equities is that inflation in the developed world remains relatively benign. This helps to ensure that significant rate hikes largely remain off the table. Also, low levels of inflation have historically been supportive of price-to-earnings multiples.

A third support for risk assets is the recovery of global growth. The chart below shows the global “heat map” for purchasing managers’ index (PMI) data for the manufacturing sector. Heat map colours are based on the PMI relative to 50, which indicates an expansion or contraction of the sector. The proliferation of greener shades on the chart as we come into 2014 shows the rebound in economic activity taking hold.

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Against this backdrop of stronger economic growth, the outlook for corporate earnings growth is also improving, particularly in the US. The broad message is that US earnings should continue to grow at a mid single-digit pace, at least, in the near term, as the economy expands and the forces that usually combine to squeeze margins remain relatively contained. In Europe, all the ingredients are in place for better earnings growth to materialise, and this should help to take the markets higher in the coming year.

Although these three pillars justify a continued overweight to equities, we think investors still need to moderate their expectations for this year. Markets have come a long way since the lows of 2009, after all, and investors should not expect a repeat of last year’s high returns.

Attention-grabbing headlines are always likely to make investors nervous, whether it be the possibility of a further flare-up in Ukraine/Russia tensions, some form of Middle East oil shock, stronger-than-expected deflationary pressures in the eurozone, or some other tail risk event. At present, investors should focus on what they can see. That is loose monetary policy, little threat of inflation and an improving global economy. With volatility likely to return to normal levels, which is nothing to be feared, the absence of another big shock may well nudge investors to direct excess liquidity towards the stock market.

Kerry Craig is global market strategist at J.P. Morgan Asset Management