Global Equity Outlook
First Quarter 2015
- The final quarter of 2014 delivered a large amount of troubling news items to global investors’ doorsteps. Plunging oil prices, weakness in China, return to recession in Japan, continued stagnation in Continental Europe, a collapsing ruble, and the possibility of an interest rate hike in the U.S. all pointed to tricky times ahead for investors. In this environment, stocks advanced modestly in the U.S. but declined across the other regions.
- While the U.S. led all other markets in performance, buoyed by some encouraging domestic economic and employment data, returns were moderated by concerns about the sustainability of a widespread global recovery.
- Emerging markets (EM) saw patchy performance on a country-by-country basis, amid ongoing concerns about slowing global growth, declining commodities prices, and the strength of the U.S. dollar.
- The European malaise continued. Equities were down again for the quarter, positioning the region as the global laggard year to date. Despite repeated pledges by the European Central Bank (ECB) that it would take any accommodative steps necessary, deflationary pressures and sluggish economic activity prevailed.
- Geopolitical worries remained a concern. Ongoing sanctions against Russia and dropping oil and commodity prices have battered that economy. The Russian currency dropped by approximately 20% toward the end of the quarter in response.
- Despite more bad news than good, equity valuations still appear reasonable in the U.S., attractive in Europe, and still below historical averages in emerging markets.
- Shifting global conditions have led us to become skeptical of the sustainability of the global recovery, particularly given the disparity in the extent of recovery seen in the various world economies.
- The U.S. economy appears poised to continue to improve into the new year as the recovery gains momentum and corporate earnings increase. Improving news on the employment front and a solidifying housing market suggest consumer confidence will continue to strengthen. Further signs of improving sentiment were seen in stronger-than-expected retail sales data over the critical holiday shopping season.
- Europe’s lack of sustainable improvement continues to confound economists and investors alike. Improvement can be seen on a country-by-country basis, mostly in the larger Western European economies with exposure to the U.S. recovery, such as Germany and the U.K., and in some of the financials in the peripheral markets of Ireland and Spain. Contrastingly, commodity- and energy-related economies (e.g., Norway and Russia) are suffering amid plummeting prices. Recently announced quantitative easing moves should help stem the deflationary tide.
- A second consecutive quarter of negative economic activity signaled Japan’s return to recession. As such, Prime Minister Shinzo Abe’s economic reforms and the Japanese recovery remain tenuous. The government’s recent decision to delay the next scheduled consumer tax increase and the tailwind a weaker yen is providing to manufacturers and exporters are positive signs.
- Sluggish growth in China, pressure on oil and commodity prices, and the strong U.S. dollar should continue to handcuff emerging markets, despite solid performance relative to most developed markets and generally favorable earnings news.
Two major news items dominated events this past quarter. The collapse of oil prices and the further decoupling of the recoveries of the U.S. and the other global economies captured investors’ interest and drove performance in the fourth quarter.
Slowing growth in China (the world’s second-largest oil importer), languishing recoveries in Japan and Europe, and increased production resulted in an oversupply that sent prices plummeting in the second half of the year. Brent crude oil futures were down about 50% from their June peak and dropped by almost one third during the fourth quarter alone (from $96.33 on September 30, 2014, to $60.01 on December 16). Not surprisingly, this decline severely affected energy stocks around the globe along with oil-related economies such as Mexico, Russia, Norway, Venezuela, Canada, and Iran. The world’s two largest oil producers, the U.S. and Saudi Arabia, account for approximately 23 million barrel per day, more than one quarter of overall global production. Advances in U.S. shale extraction technology and the Saudi Arabian/OPEC decision not to cut production in the face of the oversupply greatly contributed to the precipitous price decline.
The flip side of the oil story, of course, is that the less consumers must spend on energy, the more they have at their disposal for other goods and services. This has been estimated to be as much as $12,000 per capita in the U.S. over the coming year. That should be good news for consumer discretionary companies (e.g., retailers, travel, and restaurants). And the less businesses have to commit to energy costs, the greater their margins, which could be a boon for those heavily influenced by the cost of fuel (e.g., automakers, airlines, shipping, and logistics companies).
You Go Your Way, and I’ll Go Mine
The second big news item affecting world markets during the quarter was divergence between U.S. economic expansion and that of the rest of the world. After the global financial crisis of the late 2000s, unprecedented levels of stimulus, led by the Federal Reserve’s (Fed’s) bond-buying program, pumped liquidity into the U.S. monetary system and helped make it the engine driving global recovery.
But now the U.S. and the other global markets have decoupled, and both economic recovery and monetary policies have begun to diverge. The cessation of the Fed’s accommodative policies side-by-side with additional easing by Japan, Europe, and China have combined to boost the U.S. dollar higher against most major currencies; this has only exacerbated the challenges facing non-U.S. markets.
While the U.S. economy continues to strengthen despite the end of quantitative easing—the Fed is even contemplating an interest rate increase in 2015—things are not as encouraging in other parts of the world. Europe remains mired in a deflationary funk and is initiating more aggressive accommodative actions. Japan has slipped back into recession, marked by two consecutive quarters of economic contraction, despite its government’s own stimulus programs to fuel inflation and weaken its currency to make exporters’ goods more attractive. China’s central planning committee has been reducing rates and introducing other stimulus moves to combat slowing growth trends. Emerging markets, tied to the fortunes of China and the developed world as they are, continue to struggle despite better fiscal balance sheets and encouraging corporate earnings trends.
All this confirms our view that a bottom-up, stock-by-stock analysis is the appropriate way to uncover opportunities for sustainable growth in such a complex, fragmented environment.
European markets declined for the second consecutive quarter, and trailed most of the other global regions. ECB Chairman Mario Draghi has stepped up language about taking any and all steps necessary to stimulate the region’s economy and reverse its deflationary spiral. However, oil is one of the continent’s chief imports. It remains to be seen whether lower prices will stimulate economic activity as consumers and businesses spend their surpluses or whether they will put even more deflationary pressure on the economy.
Aggressive stimulus policies, once fully implemented, should aid small- and mid-sized companies who generally have the greatest difficulty in times of tight monetary conditions. They could also accelerate the current trend of a weakening euro versus the U.S. dollar and other major currencies. A weaker euro and stronger dollar could act as a tailwind for Europe by making European manufacturers and exporters more competitive globally. Additionally, well-structured financial institutions should continue to benefit, particularly in the peripheral economies of Portugal, Ireland, Italy, and Spain.
The U.S. economy, once the engine driving global recovery, continues to chug along,but the rest of the cars have decoupled from the engine and are now trailing away. U.S. stocks led all global regions in the fourth quarter, despite increased volatility, as the major indices hit numerous new highs. Despite these new peaks, U.S. equities appear reasonably priced to us, with earnings multiples yet to reach levels seen in previous bull markets.
The employment picture continues to improve. New weekly jobless claims dropped below 300,000 in early December and came in below consensus estimates, according to the Bureau of Labor Statistics. Continuing claims, a proxy for the long-term unemployed, dropped to their lowest levels since December 2000.
If retail data is any indication, consumers appear ready to finally breathe a sigh of relief and put the recession behind them. Gray Thursday (formerly known as Thanksgiving), Black Friday, and Cyber Monday shopping data exceeded all consensus estimates. U.S. shoppers kicked off the holiday season by spending more than $22 billion over Thanksgiving weekend, according to ShopperTrak, turning their lower gas price dividends into millions of smartphones, tablets, and HDTVs.
This appears to be good news for consumer discretionary, consumer staples, and select industrials stocks (such as automakers). U.S. energy companies, however, especially in shale exploration and extraction, are not faring as well from the oil price decline. Shale extraction is expensive, and at these significantly lower prices, several major exploration companies have announced cutbacks in capital expenditures and exploration deals. Speculation exists that this was the intention of OPEC all along when they decided not to cut output despite falling prices. The long-term outcome from this scenario remains to be seen, and we are watching it closely.
The other potential cloud on the horizon is the increasingly likely possibility that the Fed will raise interest rates sometime in 2015. While such a move is anticipated and is being priced into the markets, there remains a chance that it could prove a shock to the system after the years of easy liquidity and slow or even stall the recovery.
After climbing out of recession in 2013, fueled by Prime Minister Abe’s economic reforms, Japan slipped back into recessionary mode with economic contraction in the second and third quarters of 2014. While the magnitude of the contractions was slight, this was a disappointing turn of events for global investors. In response, the government announced additional monetary easing in October, spurring Japanese stocks to rise.
There are other reasons for optimism as well. Increased capital spending, notably by metals producers and makers of smartphone components, and an uptick in corporate earnings reports support the view that Japan should return to economic growth again by 2015. Also, the recent electoral victory by Abe’s party suggests the Prime Minister has received a mandate to see his policies through.
Overall, this recent turnabout underscores the uncertainty surrounding the long-term sustainability of the Japanese reforms, and we remain concerned about the economy going forward. The yen continues to weaken, benefiting export- and industrial-based companies, but consumer activity and capital investment have been uneven and equities have stagnated, despite better earnings.
Emerging Markets (EM)
Emerging markets trailed all other regions for the quarter, a victim of collapsing oil and commodity prices and a soaring U.S. dollar. The picture for EM economies remains murky for several reasons: the effects of a strengthening dollar, slowing global growth, and ongoing geopolitical concerns.
The effects of a strong dollar should concern EM investors looking ahead. The divergence of central bank monetary policies is expected to continue until sustainable, long-term improvement is seen in Europe, Japan and other developed markets. The pressure a rising dollar puts on commodity prices and its effect on current account balances for EM economies should continue to create a headwind for EM markets as a whole.
Stagnation in China, Europe, and Japan are reasons for concern as well. Emerging markets’ reliance on these major developed markets as trading partners means that the longer it takes them to shake off their deflationary torpor and achieve sustainable growth, the longer EM economies could suffer.
Developing markets are often painted with the same brush. So, despite positive signs in several individual countries—India, for example is benefiting from increased confidence after election of a reform-minded government— ongoing geopolitical issues will trouble investors about the entire region. Russia’s conflict with Ukraine and the collapsing ruble, currency worries in Brazil, and political unrest in Hong Kong, Thailand, Greece, and the Middle East present additional challenges.
Lower oil prices will affect the individual markets differently. Net importers such as Turkey, Chile, and most of Asia could see a benefit, while oil-related economies like Mexico, Venezuela, Colombia, and of course Russia will likely be hardest hit. It is worth noting that lower oil costs for importers could help offset some of the negative effects of a strong U.S. dollar on current account deficits.
China continues to slow. The central committee has responded with additional stimulus as well as new regulatory reforms to increase transparency. A bright spot remains China-focused internet-related names as the country with the largest number of internet users sees greater adoption, penetration, and expansion rates in the internet, mobile and e-commerce areas. The longer-term question remains: As China transforms from an investment- and industrial-based to a service-based economy, how will the central committee’s new plenary directives affect growth? This is another ongoing situation we are watching closely.
We expect emerging markets to continue to moderate into next year. While there are multiple reasons to be positive, such as improved fiscal responsibility, better balance sheets, improved governance, and solid earnings growth, we remain aware that the noted headwinds will continue to challenge emerging market economies on a case-by-case basis.
Longer term, Asia’s developing economies are likely to rebound relative to developed markets, despite recent performance lulls, which, in our view, are the result of the discussed short-term factors. China’s slower infrastructure spending has hurt commodity- and materials-based names, but they should rebound along with the inevitable normalization of economic activity in China and stronger recovery in the major Western economies. We would also expect to see manufacturers and exporters, especially those tied to global growth, benefit as economic conditions strengthen in China, Europe, and Japan.
As dedicated bottom-up stock pickers, we are committed to keeping short-term market trends in perspective as we maintain our disciplined investment approach. Though optimistic after several consecutive quarters of growth, many investors remain cautious about fixed income, U.S., Europe, Japan, and emerging markets investments alike. We believe that by analyzing opportunities on a company-by-company basis, regardless of short-term market conditions, we will be able to uncover attractive stocks that can offer the earnings acceleration potential that is the cornerstone of our investment process.
The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
For detailed descriptions of indices or investing terms referenced above, refer to our glossary.