Is the holiday over?
Our extended holiday in the market has now lasted almost five years! Since the bottom of our market after the 2008 crash the JSE has returned over 150%, or an annualised return of 25%. Two thirds of this return was driven by a rerating of the market from a P/E of below 8 times to the current P/E of over 16 times. Compared to historical ratings this is at the high end, as per figure 1.
So what can drive our market further? Despite the high valuation levels there are several factors that continue to support markets:
1) Global growth showing tentative signs of recovery
Recent economic indicators from the US continue to paint a picture of a gradually recovering economy. In contrast, Europe continues to contract on a year on year basis. Chinese growth, although at lower rates than before, has stabilised at very healthy levels and remains one of the biggest contributors to global GDP growth. In fact China, in combination with emerging markets, is expected to contribute over 80% of global GDP growth over the next two years. In South Africa, GDP growth is expected to remain positive, but at subdued levels below 3%. We are, however, expecting low double digit earnings growth from our market over the next two years, which puts our market on a 13 times P/E two years out.
2) Monetary conditions to remain stimulatory
Globally, interest rates are at ultra-low levels with real rates in most developed economies being negative as central banks continue to try and revive the subdued economic recovery. Despite some recovery in the unemployment rate in the US, indications are that monetary conditions will remain stimulatory until the unemployment rate drops below 6.5%. At the current levels of job creation, this will probably only be achieved in late 2014 or 2015. This raises the risk of runaway inflation down the line (which should be good for real assets), but whilst capacity utilisation is still below 80% this risk remains contained. The challenge will be to retain stimulatory rates if growth remains subdued but inflation starts picking up.
3) Relative valuations remain supportive of equities
Given the compressed global interest rates, equity yields suggest great relative value. In fact, as can be seen from figure 2, the gap between equity yields and bond yields are at quite extreme levels. You can effectively earn a 3.8% excess return per year from equities over bonds, even without any earnings growth over the next 10 years!
Corporate credit spreads have also become compressed in the global search for yield. This effectively enables corporates to borrow at rates lower than the yield on their shares, enabling them to do share buybacks that are earnings enhancing from day one. It also encourages merger and acquisition activity. It is therefore no surprise that share buybacks and mergers and acquisitions combined are running at the highest levels they've been in the last five years. So while policy rates stay so accommodating, it should remain supportive for equities.
Although the case for equities is constructive, many global macro risks remain. Given the current low levels of volatility, protection costs have become significantly cheaper. The VIX index (figure 3) gives an indication of the cost of protection, which is currently low. The opportunity cost of protection is therefore low enough to retain a high equity exposure, but with downside protection.
So, whilst we've had an extensive holiday in the market, we don't have to rush back home just yet. Apply some sunscreen and enjoy the beach!