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One of the biggest fears for global investors right now is that many of the emerging economies are facing capital outflows and will need to raise interest rates to hold onto those flows. Higher interest rates choke off economic growth which, in turn, would undermine the global economic recovery since the emerging economies now account for over 30% of world growth. Moreover, after the financial crisis of 2008, no one is being complacent about the risks from financial contagion. But what is forgotten is that many of these emerging economies have high savings rates, meaning that they can fund their own growth. China is a classic case of this as it has a very high consumer savings rate and the government has massive amounts (over US$3 trillion) of liquid assets available if there are any financial market shortfalls.
Stocks were overdue for some sort of correction and, in our view, this ‘emerging markets debacle’ is just providing the reason needed for a pullback in prices.
Stocks remain fairly valued versus long-term averages, the global economy continues to expand and interest rates are expected to remain below normal levels for an extended period. Stocks will eventually go into another bear market but we don’t see that happening until inflation starts to return, interest rates begin to head higher and economic growth is above long-term averages; none of those conditions exist currently. The only negative we see are high levels of bullishness among investors and a sense of complacency about risk. Those are conditions for a correction, not a bear market. Our strategy, therefore, is to add to core stock positions in financials, technology, energy and basic resources on any significant (i.e. more than 5%) weakness.
On the economic front, we are in the heart of earnings season, and the news once again is good. With about a quarter of S&P 500 members having reported so far, Q4 earnings and revenues are coming in ahead of Wall Street expectations. The earnings beat ratio stands at 67%, which is in-line with the past three-year average, and the revenue beat ratio is solid at 62%. Earnings are exceeding forecasts set at the beginning of the earnings season by +2.1%. Revenue growth remains modest but it should gain traction over the coming quarters with global growth accelerating. Profit margins are expanding to 9.8% (another record high). It’s still early innings in reporting, but earnings are en route to hit a new record high in Q4. Further supporting the bullish case, the BAML Global Earnings Revision Ratio jumped from 0.76 to 0.89 in January, the highest level in three years. The improvement was broad with the Ratio rising in most regions and global sectors during the month. If sustainable, this suggests future earnings trends may not be as poor as many investors believe.
Canada is also starting to look better and should narrow the performance gap with the U.S. market that it has seen over the past three years. The earnings recovery in 2014 will be driven be an improvement in bank earnings growth, an accelerating recovery for the life insurance companies and a bounce in resource company earnings. Energy stocks will be aided by a falling Canadian dollar as well as a narrowing of the spread between U.S. light oil (WTI crude) and heavy Canadian crude oil (WCS). The chart below shows how earnings growth flattened over the past three years after the strong recovery in 2009-10. Incorporating current earnings forecasts, Canadian profits should rise back above the all-time high seen back in 2008. Like we pointed out in the U.S. two years ago, if earnings go back up above their all-time highs, then there’s no reason that stock prices shouldn’t go along as well.