Pretty fundamental to a view on global equities is an opinion on where we are in the profits cycle. Some would argue that profit margins have peaked. However, having seen corporate profitability fall significantly during 2008/2009 it would certainly be unusual if barely two years on profitability has ‘topped out’. Research suggests that certainly in the US, profit margins peak once the output gap has closed. This is the spare capacity in the economy which usually increases during recessions as companies scale back production and operations. When things improve they are then able to scale up their operations both more quickly and, importantly for profit margins, cheaply. 

A key driver for valuations is not just profit margins but also the return earned by shareholders, Return on Equity (ROE). The lowest quality, and easiest, way for a company to boost its ROE is to increase leverage. The private sector has been deleveraging over the last 7 years and this has dented shareholder returns. As the economic environment improves, leverage will increase and further boost ROE.  

The investment share of GDP in the major economies is close to an all-time low due to a combination of reduced consumption, governments spending beyond their means and reduced business investment. Low consumer confidence means consumption is unlikely to drive a rebound in growth. Most governments have belatedly made attempts to slow the growth in their spending but this is easier said than done. That leaves the elusive business investment. Business investment is a very long way below trend to the tune of around $600 billion annually. A meaningful pickup in investment could really kickstart growth and result in a pickup in employment that would subsequently see consumption more prominent in driving growth. An increase in business investment could certainly send stock markets higher. 

With many having given up hope for the advanced economies, hopes now rest on the emerging economies led by China. It has been a pretty challenging environment thus far in 2011 due to a decline in valuations that has come in tandem with higher inflationary pressures. Certainly in China, the major inflationary pressure has come from higher food prices. The good news is that in the absence of further increased soft commodity prices this upward pressure will ease as 2011 progresses into 2012. This could certainly set the tone for renewed outperformance by developing markets potentially before year-end.

July 2012

Sources: Thomson Reuters, OECD estimate, Credit Suisse, GFMS, BNP Paribas, MSCI, Factset, Morgan Stanley Research