Wilmington Trust's Investment Strategy Team (IST) met last week and cut the emerging stock markets' exposure of its model asset allocation strategies to match the strategies' benchmark weights. The proceeds were shifted into large- and small-capitalization stocks in developed international markets. Recent reports have increased our concerns about the prospects for emerging markets' rates of economic growth. Data out of China has been pointing toward lower growth, which was confirmed by the results for the second quarter, showing 7.5% year-over-year growth, down from 7.9% achieved as recently as the fourth quarter of 2012. Brazil's economy appears to be struggling with inflation and political unrest, which does not augur a return to stronger economic performance. The recent elections in Japan mean that Japan will continue to take aggressive monetary actions, curbing South Korea's growth prospects as the yen falls and Japan becomes more competitive with South Korea. Corporate earnings expectations across the emerging markets have been declining, with profit growth estimates for 2013 falling by 6 percentage points over the past three months. My colleagues and I considered moving to a below-benchmark weighting in emerging stock markets, but we rejected the idea for two reasons. First, valuations have improved with recent price declines. Second, emerging markets could begin to improve with appropriate policy adjustments, such as the recent decision by Chinese authorities to remove restrictions on lending rates.
On the rise: Economic prospects in Japan, Western Europe
The decision to raise our model allocations to developed international stock markets reflects our belief that economic growth and hence corporate earnings in both Japan and Europe are likely to improve. European authorities appear to be waiting for the German election before pursuing further pro-growth initiatives. While the history of European leadership has been to wait for a crisis before acting, we believe nonetheless that they have moved in the right direction to shore up the financial system. The creation of a banking union and efforts to ensure that the banks have adequate capital are important steps to facilitate credit availability. The European Central Bank (ECB) has been the least aggressive major central bank when it comes to easing monetary policy. The upcoming German elections may give ECB policymakers more leeway to act. As noted, the recent election in Japan will give Prime Minister Shinzo Abe more flexibility to implement policies that should expand growth and build corporate profits. Most developed international small-cap companies are in the Western Europe and Asia-Pacific regions; they are in good locations to benefit from improvements in continental Europe and Japan.
We discussed putting the proceeds from the sale of emerging market equities into the U.S. equity market but rejected the idea. While the trajectory of the U.S. economy appears solid in relation to the paths of competing economies, we were uncomfortable adding to our exposure to the U.S. stock market, given the significant price gains it has recorded in recent months. Considering both valuations and momentum, we believe developed international markets offer a more attractive entry point than the U.S. market.
On the road to normality, perhaps: Inflation-linked bonds
At our meeting we also discussed our weighting to inflation-linked bonds, which include Treasury Inflation-Protected Securities (TIPS). We have not been worried about inflation because of both excess productive capacity in the global economy and many countries' efforts to devalue their currencies. In addition, TIPS' prices have been high. The yield of TIPS basically includes an inflation-tracking component and a real—that is, above-inflation—component. The real yield has been so low that we have been underweight these types of bonds. Normally, one would expect the real component to be positive, but recently the real yield on many TIPS has been negative, meaning investors would not keep up with inflation (before taxes) on a bond held to maturity. For example, the real yield on 10-year U.S. TIPS was negative for all of 2012. This year the real yield climbed from about –0.75% to 0.50% before dropping back to about 0.40%. As the real yield moves higher, we will consider increasing our allocation to this asset class.
In the U.S., housing offsetting federal spending cuts, tax hikes
Our economic outlook remains relatively stable. Domestically, we continue to expect a modest dip in U.S. economic activity, with inflation-adjusted annualized growth in the range of 1.6–2.2% in the second and third quarters before the economy returns to its underlying trend rate of growth of roughly 2.5% in the fourth quarter and into 2014. The dip primarily reflects the federal spending sequester and tax increases put in place earlier this year. We expect the impact of this fiscal restraint to fade as the year passes. Housing remains a major support for the domestic economy, and while the recent increase in interest rates has slowed re-financing activity, homebuilder confidence has continued to rise.
Economic growth worldwide should approach 3% next year, up from about 2% in 2013. However, revisions to these numbers have been mostly in a downward direction with the exception of Japan. German growth is expected to reach about 1.5% in 2014 and is critical to pulling much of the rest of Europe out of its current recession. Earnings growth in developed international markets for 2014 is expected to be around 12% versus about 5% for 2013, reflecting the belief that conditions will continue to improve.
Corporate profits expected to strengthen as year progresses
Finally, we are in the midst of corporate earnings season. With 255 of the S&P 500 Index companies reporting—companies that account for 61% of the index's total market capitalization—72% of companies have reported second-quarter profits that topped analysts' consensus estimates. In aggregate, the earnings of the 255 firms exceeded expectations by about 3.8%. Importantly, reduced third-quarter earnings guidance from company managers has not translated into reductions in full-year estimates, which have risen about 1.2% since the start of the reporting period. It has been harder for companies to top estimates of their second-quarter sales, with only 53% of companies doing so thus far. The median level of outperformance has been just 0.1%. Growth in second-quarter earnings is now expected to amount to about 1%, rising to 3.2% and 9.8% for the third and fourth quarters, respectively. Revenues are expected to grow about 1% in the second quarter before climbing 2.7% and 2.6% in the next two quarters.
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