February 2015 Highlights Though whipsawed for much of January, global equity markets have been resilient. We note that emerging markets are leading the pack, which is unusual in a time of USD appreciation. Globally, we note that Brent oil is diving while leading indicators are trending up, a development likely to benefit most households. With expansion now in full swing, the U.S. earnings outlook remains favourable. A quarter of the way into the Q4 earnings season, outcomes are running above expectations. Though some sectors of the S&P 500 are beginning to feel drag from the strong U.S. dollar, we doubt this will have much effect on the economy as a whole. True, about 40% of S&P 500 profits are earned overseas. But for national-accounts profits the share falls to 20% . At this juncture, we remain comfortable with our recommendation to overweight equities relative to our benchmark while maintaining a slight underweighting in fixed income products. We are staying with an overweight recommendation for the S&P/TSX early in 2015. This call hinges on our assumption of lower oil production and a delay in U.S. rate hikes (in order to limit USD strength). Our year-end targets are 16,200 for the S&P/TSX and 2,220 for the S&P 500. Stéfane Marion [email protected] Matthieu Arseneau [email protected] MONTHLY EQUITY MONITOR A volatile start to 2015 World: A highly unusual dynamic OECD leading economic indicators and Brent oil price Though whipsawed for much of January, global equity markets have been resilient. At this writing the MSCI AC World index is up 0.8% year to date with most regions positive. We note that emerging markets are leading the pack, which is unusual in a time of USD appreciation. Global equity market performance (Year-to-date) MSCI AC World 0.8 MSCI World 0.6 MSCI USA 1.3 4.2 MSCI Pacific ex Jp 2.9 1.4 MSCI EM 3.1 MSCI EM EMEA 5.2 MSCI EM Latin America -1.9 MSCI EM Asia % 3.8 -3 -1 1 3 5 NBF Economics and Strategy (data via Datastream) P/Es since 1988: MSCI World and MSCI Emerging Market Price to 12-month forward earnings (left) 130 World 120 (left) 110 100 98.5 98.0 97.5 97.0 90 80 70 60 96.5 96.0 95.5 Brent oil 40 (right) 50 30 2007 2008 2009 2010 2011 2012 2013 2014 20 2015 But there’s more. The price of food has also been falling (second chart below) and so have interest rates. That makes three sources of relief for the disposable income of global consumers. The lift they bring will be felt most in urban areas of emerging economies, where food and energy generally account for two-thirds of the CPI basket. Thus it is hardly surprising that the consensus expects double-digit earnings growth for the MSCI EM index (10.1%, table). World: Food prices since 2007 CRB Foodstuffs (in USD) 28 Ratio 520 Index 26 500 480 24 460 22 440 20 420 −20% 400 World 18 380 16 360 14 340 12 320 300 10 280 8 6 160 150 OECD 140 NBF Economics and Strategy (data via OECD) MSCI Europe MSCI Japan US$ / barrel 170 100.5 100.0 99.5 99.0 95.0 2006 -1.2 MSCI Canada 102.5 Index 102.0 101.5 101.0 Emerging 1990 1995 2000 2005 2010 2015 NBF Economics and Strategy (data via Datastream) 260 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 2007 2008 2009 2010 2011 2012 2013 2014 NBF Economics and Strategy (CRB data via Datastream) So why are emerging markets outperforming? To answer this question we need perspective on the impact of a supply-induced oil-price collapse. Globally, we note that Brent oil is diving while leading indicators are trending up, a development likely to benefit most households. 2 MONTHLY EQUITY MONITOR MSCI indexes: % EPS growth, y/y and 12-month-forward MSCI AC World MSCI World MSCI USA MSCI Canada MSCI Europe MSCI Pacific ex Jp MSCI Japan MSCI EM MSCI EM EMEA MSCI EM Latin America MSCI EM Asia 1/27/2015 2013 8.1 6.4 8.4 -6.2 -5.4 0.0 NA 19.7 87.0 5.4 8.3 2014 4.4 5.1 5.0 12.6 2.1 8.1 74.8 0.0 -13.1 -8.9 7.1 2015 6.2 5.6 5.2 -2.6 6.8 0.7 11.1 9.7 2.6 13.4 11.1 2016 12.2 12.2 13.0 14.8 12.2 8.3 11.0 11.9 12.6 17.3 10.5 12 forward growth 7.0 6.6 6.3 -0.6 7.3 3.6 11.0 10.1 4.5 13.7 11.0 NBF Economics and Strategy (data via Datastream) U.S. earnings trending up This low interest rate environment has significant ramifications on relative valuations of financial assets. We note that the current gap between the U.S. earnings yield and long-term interest rates is unusually large for a U.S. expansion (the current one began officially in September 2013). Based on this perspective, equities do not look particularly expensive. U.S.: Valuations since 1960 Though the outlook for global growth is generally promising, industrial production will grow more slowly than in the past decade. The most recent data, for November, show volume industrial production in emerging Asia up 4.2% from a year earlier, the slowest pace since the 2008-09 recession (chart). This deceleration is consistent with China’s decision to emphasize the development of its service economy over the addition of industrial capacity. The end result is that the trend growth of global IP is probably closer to 2% than to 3%-4% (chart). S&P 500 earnings yield, Moody’s Baa corporate yield, 30-year government bond (constant maturity) 18 % 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1960 S&P 500: 6.2% Baa: 4.5% 30-years: 2.5% 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 NBF Economics and Strategy (data via Datastream) Global industrial production since 1995 24 % y/y 20 16 12 Emerging Asia 8 4 World OECD 0 Asian Crisis -4 -8 -12 -16 -20 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 NBF Economics and Strategy (data via CPB) That doesn’t mean global GDP and earnings cannot grow faster than industrial production in 2015. In fact, all eyes should be riveted on services this year: this is the part of the economy most likely to benefit from higher consumer spending as energy and food prices decline and highly stimulative monetary policy in most regions of the world keeps interest rates low all along the yield curve (and negative in some countries). Moreover, with expansion now in full swing, the U.S. earnings outlook remains favourable. A quarter of the way into the Q4 earnings season, outcomes are running above expectations. Of the 128 companies reporting at this writing, 97 have surprised on the upside. The overall “beat factor” is an impressive 4.6%. Though some sectors of the S&P 500 are beginning to feel drag from the strong U.S. dollar, we doubt this will have much effect on the economy as a whole. True, about 40% of S&P 500 profits are earned overseas. But for national-accounts profits the share falls to 20% . 3 MONTHLY EQUITY MONITOR U.S.: Profits remain firm Before-tax profits (with IVA and CCA), national-accounts basis Total 2,200 $ billion 2,000 Domestic 1,800 1,600 1,400 1,200 The domestic economy accounts for 80% of all U.S. profits 1,000 800 600 400 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 NBF Economics and Strategy (data via Datastream) The story for 2015 is quite different from that of the early days of recovery from the last recession, when the U.S. needed exports for an unusual portion of its growth. This time around, we think the focus must be on domestic indicators – consumption, construction, the labour market. Particularly encouraging is the January surge of consumer confidence coupled with the large rise in the share of survey respondents expecting their incomes to increase in the next six months (chart). increases both downside risks to the inflation profile and financial stability risks.” Consequently the central bank lowered its inflation forecasts, projecting that neither core nor headline inflation would return to 2% before late 2016. The BoC move sank the Canadian dollar to a new multi-year low of 80 cents US. Many investors want it lower still. While a small depreciation might still be possible – we see the Bank cutting its overnight rate another 25 basis points – we think the CAD is near its bottom. After all, it has depreciated more than 20% over the last 24 months. As the next chart illustrates, a move of that magnitude is unprecedented. If oil prices stabilize and/or if the Federal Reserve delays the launch of its tightening (it wouldn’t be the first time this year that a central bank has surprised markets), there is scope for some firming of the Canadian dollar. Meanwhile, we note that the depreciation of the CAD over the last two years is beginning to catch the attention of equity analysts. Profit expectations for the S&P/TSX have become much less downbeat: the onemonth change in 12-month forward earnings shows signs of stabilizing for the first time since last summer (chart). Canada: Record CAD depreciation offers hope for earnings U.S.: Consumers very optimistic on future income Canadian dollar: % 24-month change % of consumers surveyed who expect to have higher incomes in 6 months 23 % 22 21 20 19 18 17 16 15 14 13 12 11 10 9 8 7 2005 S&P/TSX: change in 12-month forward earnings 32 % 28 Jan. 2015 24 16 % 12 Record CAD depreciation … 8 20 0 12 -4 8 4 -8 0 -12 -4 3-month change -16 -8 -20 -12 … offers hope for earnings -24 -16 -28 -20 -24 1-month change 4 16 1975 1980 1985 1990 1995 2000 2005 2010 2015 -32 2007 2008 2009 2010 2011 2012 2013 2014 NBF Economics and Strategy (data via Datastream and Federal Reserve Bank of St. Louis) 2006 2007 2008 2009 2010 2011 2012 2013 2014 NBF Economics and Strategy (data via Datastream) Canada: What to think? The Bank of Canada began the year with a bang, moving its policy rate for the first time in four years. Unexpectedly, the move was a cut – 25 basis points, to 0.75%. The BoC’s argument was the risk to growth posed by slumping oil prices: “The oil price shock It will be interesting to see how the Q4 announcement season unfolds. As of January 23, the consensus sees earnings growth of 5.2% from a year earlier with gains in seven of the 10 TSX sectors, led by IT (+362.5%) and Consumer Staples (+46.8%). Materials (−21.5%) and Utilities (−21.0%) are expected to be the laggards. 4 MONTHLY EQUITY MONITOR Asset allocation At this juncture, we remain comfortable with our recommendation to overweight equities relative to our benchmark while maintaining a slight underweighting in fixed income products. Our year-end targets are 16,200 for the S&P/TSX and 2,220 for the S&P 500. We are staying with an overweight recommendation for the S&P/TSX early in 2015. This call hinges on our assumption of lower oil production and a delay in U.S. rate hikes (in order to limit USD strength). Though the timing of a supply response to sharply declining crude prices is uncertain, we think U.S. oil output could decline as soon this year. The most recent report from Baker Hughes shows a sharp contraction of the U.S. rig count in January. As the next chart shows, the decline in the number of horizontal rigs (used for shale-oil production) is the largest since the recession of 2008-09. We also note that U.S. output dipped at that time and then was stable for two years. Change in number of horizontal rigs vs. U.S. weekly output Thousands of barrels per day* 9,200 U.S. field output (right) 120 80 40 8,800 8,400 8,000 7,600 7,200 6,800 6,400 6,000 5,600 5,200 4,800 4,400 0 3-month change in 12-month forward earnings growth 50 % 40 30 20 10 0 -10 -20 -30 -40 -50 2002 2004 2006 2008 2010 2012 2014 Sector rotation Our sector rotation is unchanged this month. NBF Asset Allocation Benchmark NBF Change (pp) (%) Recommendation (%) Equities -40 Canadian Equities -80 Rig count (left) -120 -160 Canada: Energy sector pummelled NBF Economics and Strategy (data via Datastream) U.S.: Will the drop in rig count affect production? 8-week change wake of a full-fledged global credit crisis. There is much bad news already priced into Canadian energy stocks and we certainly do not think 2015 will be as bad as 2008-09 for the global economy. If supply stabilizes and demand accelerates with world GDP, we would expect oil prices to be about $10 a barrel higher by year end. 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 * 13-week moving average NBF Economics and Strategy (data via Baker Hughes) If this sequence is repeated, the door will be open for an energy-driven rebound of the S&P/TSX. In the last few weeks, as the next chart shows, equity analysts have slashed earnings expectations to the same extent as in the 2008-09 recession, when the fall of oil prices reflected concerns over demand in the 30 33 U.S. Equities 10 12 Foreign Equities (EAFE) 10 7 5 8 30 30 Emerging markets Fixed Income Canadian Bonds Foreign Pay Bonds 0 0 Real Return Bonds 10 5 Cash 5 100 Total NBF Economics and Strategy 5 100 5 MONTHLY EQUITY MONITOR NBF Market Forecast NBF Market Forecast Canada United States Index Level S&P/TSX Actual Q4 2015 (Est.) Jan-27-15 Target Index Level 14,834 16,200 S&P 500 Q4 2015 (Est.) 935 446 17.3 Q4 2015 (Est.) 0.46 1.84 Assumptions Assumptions Level: Earnings * Dividend PE Trailing (implied) Treasury Bills (91 days) 10-year Bond Yield 910 435 16.3 0.62 1.43 * Before extraordinary items, source Thomson Level: Earnings * Dividend PE Trailing (implied) Treasury Bills (91 days) 10-year Bond Yield Actual Q4 2015 (Est.) Jan-27-15 Target 2,030 2,220 116 40 17.4 0.02 1.83 Q4 2015 (Est.) 126 44 17.6 Q4 2015 (Est.) 0.69 2.28 * S&P operating earnings, bottom up. NBF Economics and Strategy 6 MONTHLY EQUITY MONITOR NBF Fundamental Sector Rotation - February 2015 Name (Sector/Industry) Recommendation S&P/TSX weight Energy Energy Equipment & Services Oil, Gas & Consumable Fuels Overweight Overweight Overweight 21.5% 0.8% 20.7% Materials Chemicals Containers & Packaging Metals & Mining * Gold Paper & Forest Products Market Weight Underweight Market Weight Market Weight Market Weight Overweight 12.1% 3.5% 0.2% 2.5% 5.4% 0.5% Industrials Capital Goods Commercial & Professional Services Transportation Market Weight Overweight Underweight Market Weight 8.6% 1.7% 0.7% 6.3% Consumer Discretionary Automobiles & Components Consumer Durables & Apparel Consumer Services Media Retailing Underweight Underweight Overweight Underweight Market Weight Underweight 6.3% 1.6% 0.6% 0.9% 2.2% 1.2% Consumer Staples Food & Staples Retailing Food, Beverage & Tobacco Underweight Underweight Underweight 3.7% 3.0% 0.7% Health Care Market Weight Health Care Equipment & Services Market Weight Pharmaceuticals, Biotechnology & Life Sciences Market Weight 4.1% 0.8% 3.3% Financials Banks Diversified Financials Insurance Real Estate Market Weight Market Weight Market Weight Overweight Market Weight 34.1% 21.2% 1.4% 6.5% 5.1% Information Technology Software & Services Technology Hardware & Equipment Overweight Overweight Market Weight 2.4% 1.8% 0.6% Telecommunication Services Underweight 5.0% Utilities Underweight 2.3% * Metals & Mining excluding the Gold Sub-Industry. 7 MONTHLY EQUITY MONITOR ECONOMICS AND STRATEGY GROUP 514-879-2529 Stéfane Marion Chief Economist & Strategist [email protected] Paul-André Pinsonnault Senior Fixed Income Economist [email protected] Krishen Rangasamy Senior Economist [email protected] Marc Pinsonneault Senior Economist [email protected] Matthieu Arseneau Senior Economist [email protected] General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. 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