Written by Nathan White, Chief Investment Officer of Paragon Wealth Management
Overall, we currently see a positive year in 2013 for equity markets. The negative effects of higher taxes and somewhat lower government spending will be offset by improved corporate spending and economic growth as the year goes on. Companies and consumers have been cautious now for years and that could finally reverse in 2013 resulting in better economic growth. This could help the market’s current low to medium valuation multiple to expand thereby benefitting stocks overall for the year. The Fed should stay in continued easing mode as they try to boost inflation. Government policy wants you to spend not save. We remain cautious on bonds and are still avoiding Treasuries and long-dated maturities. The risk for reward is still very unattractive in this area. There will be the usual ups and downs throughout the year and the now seemingly ever present uncertainty caused by government action and policy will continue to be over the market’s shoulder.
Starting to Look Abroad
It’s has been awhile since we have had a significant position in foreign markets. We have been waiting patiently since the financial crisis for the emerging markets to reassert themselves and it looks like the time has finally arrived – or at least started to. The reason this excites us is because the inherent growth story associated with emerging market countries is now coupled with attractive valuations. The past few years have seen the U.S. market outperform on a relative basis. In fact, the S&P 500 has returned about 18 percent for the last two years while the MSCI Emerging Markets Index was down over 3 percent.
We are seeing signs that the tide is starting to shift. Over the last three to six months the emerging markets area has outperformed the S&P 500 on a relative basis. The deceleration in growth rates for many emerging market economies appears to be stabilizing. Chinese manufacturing PMI improved for the fourth month in a row in November to the highest figure in seven months. This adds to the evidence that the Chinese economy is on the mend and starting to recover. By the way, when I say recover, I mean returning to an 8% growth rate. Due to their stronger fiscal situations, many emerging market countries have more flexibility in enacting economic stimulus measures. Recent moves by many countries indicate that they are starting to move more aggressively on this front. Brazilian policy makers recently cut reserve requirements for lenders to stimulate investment in Latin America’s largest economy. The recent leadership change in China has heightened speculation that more measures will be introduced to boost consumption.
The main reason why emerging markets matter is because of their growth potential. Stronger economic growth turns into strong earnings growth over the long term and that is what ultimately drives stock prices higher. Over 80% of the world’s population lives in emerging markets and their workforces are young and increasingly educated. These economies experience a structural change as middle classes emerge with individuals achieving rising levels of wealth. They are often rich in resources and labor. Their gross national incomes and per capita incomes are small compared with developed economies. As these countries open their economies and enact policy reform there is dramatic potential for their incomes to climb.
Compared with developed markets, emerging markets have historically had greater return and volatility. The volatility rises from the ever present risks inherent with emerging markets: political uncertainty, regulatory and corporate governance issues, and the dominance of state owned firms. Because of these factors, investors demand greater return to compensate for the heightened risks. The higher volatility normally associated with emerging markets will still be a factor going forward. In addition, the currencies of many emerging market countries could strengthen on a relative basis due to their stronger fiscal situations offsetting some of the possible advantage.
Normally, stocks or sectors with higher growth rates command higher valuations. Emerging markets currently have higher growth rates and lower valuations. This spells opportunity. The current price to earnings multiple for emerging markets is about 11 compared to 14 for the S&P 500. This is about a 27% difference and indicates some of the relative value that we believe exists in this area. These low valuations could help to cushion any downside if markets fall and provide more upside if markets rally. The main reason that valuations in emerging markets have come down is because their growth rates have come down from the lofty levels usually experienced when growth first kicks in. Part of the reason for the slowdown has been from the effects of the worldwide recession which emerging markets are not immune from. However, part of the slowdown comes as these economies start to develop more domestic demand and transition from relying primarily on exports. For example, China and India had growth rates of 14% and 10% respectively in 2007. Those rates have now come down to 8% for China and about 5.5% for India. By comparison, U.S. GDP growth estimates are currently around 2.5%. On the whole, we believe the better growth and cheaper valuations of emerging markets offer a compelling opportunity compared to the risks.
Other Areas of Focus
Closer to home, the U.S. sectors we like are healthcare and some of its sub-industries such as healthcare providers and pharmaceuticals. The financial sector looks favorable as it has gone through years of cutting costs and employees and is no longer burdened by toxic assets. This could set the area up for better profitability going forward. We see other intermittent opportunities in technology, homebuilders and energy throughout the year. As U.S. fiscal contentions could last all year with no quick fixes it might be time to look outside the U.S. for the best relative opportunities. U.S. valuations are reasonable at current levels considering artificial low interest rates. Retail investors are still woefully underinvested as they continue to fight the specter of 2008. This bodes well for equity markets overall and emerging markets in our opinion could be one the best areas of the market.