MSSB: Repositioning for higher inflation

Though the Federal Reserve’s second round of Quantitative Ease (QE2) wasn’t announced until Nov. 3, anticipation of and reaction to the actual news has already had some desired effects. Since late August, when Fed Chairman Ben Bernanke first raised the possibility of additional QE, US equities have gained more than 10%, inflation expectations as measured by the US TIPS market have increased by 65 basis points, the dollar has declined by about 5% and the yield curve has steepened. All these moves point to higher inflation and stronger economic growth ahead.
Given our belief that investors should never fight Fed policy, we are making adjustments to our model portfolios to better take advantage of this plan to buy up to $600 billion of Treasury securities through June 2011. Since the Fed is aiming to push inflation higher, we are increasing our exposure to inflation-linked securities to overweight from underweight. Global economic growth and a weaker dollar are likely to bolster commodity prices, so we are instituting a higher overweight position to this asset class.
To fund these higher allocations, we are reducing holdings in two other asset classes. Global REITs are up 23.5% for the year to date (through Nov. 5) and, though we believe the outlook for them remains positive, we are trimming our exposure to a less-overweight position. We are also cutting emerging market (EM) debt to market weight from our previous overweight position. Improved credit quality has helped this asset class deliver a 15.2% year-to-date return, but the spread over Treasuries is down to nearly 200 basis points—a level we consider consistent with a market weight. Specific weightings for the new allocations can be found in the tables that begin on page 24.

OPPORTUNITY IN RISK ASSETS

These adjustments do not change the thrust of broad allocations, which overweight global equities and alternative/absolute return investments while underweighting government bonds and cash. In particular, we are overweight EM equities and underweight developed-market (DM) equities. EM equities are at valuations roughly equal to DM equities, consistent with consensus earnings-per-share (EPS) expectations of 15% growth in 2011 for the MSCI World Index and 17% for the MSCI Emerging Markets Index (see Table 1). Our thesis is that EM equities will, over time, trade at a valuation premium to DM equities.
Also supporting the case for global equities is the fact that global dividend yields are attractive relative to the low yields on offer from cash or sovereign debt. Sustained profits growth should make those dividend payments and increases more secure over time. Likewise, corporate bonds offer above-average spreads over sovereign debt and should see more credit-rating upgrades than downgrades as the profits recovery continues.

GDP MILESTONE

With so much media coverage of QE2, the US midterm elections, mortgage-foreclosure controversies and “currency wars,” investors may have missed an important development in the economic recovery: At a nominal $14.7 trillion, the US economy is now larger than it was at the onset of the Great Recession. In a similar vein, the US government’s measure of total corporate profits recovered by the second quarter to 98% of its September 2006 all-time high. Strong third-quarter corporate earnings suggest that a new high for profits has been reached. With the economy and profits surpassing their old highs, would it be a surprise if equities followed suit?
Given the recent advances in global equities, some observers are questioning whether a bubble is in the making, especially in the emerging markets. Bubbles are a late-cycle phenomenon, and the EM advance, 105 weeks old, is still young. In contrast, the Japanese bubble of the 1980s lasted 382 weeks and the telecom, media and information technology bubble that burst in 2000 lasted 415 weeks (see Chart 1).
True, equities may not be as cheap as they were in March 2009, but they still represent a tremendous opportunity, in our view. The Standard & Poor’s 500 Index is 23% below its all-time high, and the ratio of S&P 500 prices to US corporate profits is quite low by historical standards. Since 1947, the ratio of the S&P 500 Index to the National Income and Product Accounts, a broad measure of corporate profits, has averaged 0.86, measured in billions of US dollars. Today that measure stands at just 0.64. If profits were to remain at this level and the ratio were to revert to its multidecade average, with share prices accounting for the entire adjustment, the S&P 500 would climb to 1650. That is 35% above today’s level of 1222—and that scenario assumes that corporate profits never grow again.

VALUATION AND DEFICITS

US and global equities have forward price/earnings ratios of about 13, at the lower end of their 40-year historical range. What’s more, investor confidence is low, in part due to challenges such as unemployment, indebtedness and the federal budget deficit. Any meaningful shrinkage in the deficit should lead to higher valuation for stocks.
Historically, lower deficits as a share of GDP have been associated with higher equity market P/E multiples, all else being equal (see Chart 3). Investors appropriately take greater comfort when fiscal policy is well-managed. As for the cyclical portion of the US deficit, economic growth helps to make progress on that front, too. For the 12 months ending Oct. 31, US federal receipts were 7.3% higher than the recent low set in January 2010. Furthermore, federal outlays for the latest 12 months were 3.3% lower than their recent high in September 2009. Consequently, the budget deficit has declined by almost $242 billion from its peak in December of last year. But what about the longer-term structural deficit?
We got an early indication of potential deficit-cutting options with the recent report by the chairmen of the President’s National Commission on Fiscal Responsibility & Reform. This bipartisan commission was modeled after the Social Security Commission of the early 1980s, then chaired by Alan Greenspan before he became Fed chairman. The Greenspan Commission recommended raising the retirement age and taxing Social Security payments; both measures were ultimately approved by Congress. Generally, the utility of presidential commissions is that they can provide political cover for politicians to do unpopular things.
The current commission will issue its full report on Dec. 1. We expect that this commission report could improve prospects for progress on the US structural deficit, like the preceding Greenspan Commission. It could also provide a blueprint for President Obama’s next budget, affording him an opportunity to move to the political center—with an eye toward getting reelected in 2012.
In the current cycle, as the deficit share of GDP drops cyclically (a given) and structurally (we’ll see), expansion of P/E multiples could become another propellant, alongside earnings growth, driving positive equity returns. Such an outcome would be better than our base case, which calls only for equity market gains in line with earnings growth.

CURRENCY WARS?

The headlines continue to be about “currency wars,” but we still think that the reality is a lot less sensational. What is fundamentally at issue is that EM countries continue to grow faster than DM ones; ergo, EM currencies should appreciate further relative to DM ones. That’s a simple consequence of the process of global capitalism and the relative GDP growth rates of EM and DM nations—but it’s not without its bumps in the road. Thus, some EM countries have resorted to some form of capital control to slow the appreciation of their currencies. Still, the G-20, meeting in Seoul, remained committed to market-driven currency values and alert to the risks of “beggar thy neighbor” competitive devaluations. On a long-term basis we expect the dollar to continue to drop, primarily relative to EM currencies. That’s an additional reason we remain overweight to EM equities within our global equity portfolio.

MIDTERMS AND POLICY

Before getting into the policy implications of the midterm elections, it is important to note that once political uncertainty is removed—in favor of either party—equities tend to do well. Since 1950, measuring returns from Sept. 30 in midterm election years, the forward one-year return for US equities has averaged 25%, with no negative observations.
As for policy, the day after the election, the White House—heretofore opposed to extending all the Bush-era tax cuts set to expire on Jan. 1—signaled its willingness to compromise. Given that, we expect a lame-duck session of Congress to approve the extension of current tax rates, including the upper-income brackets and those on capital gains and dividends. We think that’s the main reason the stock market had a nice rally on Nov. 3.
Beyond that, the combination of a split Congress and presidential veto power means that sizeable policy initiatives on the order of 2009 and 2010—such as health care overhaul or financial reregulation— simply won’t happen. Rather the default will be gridlock. For example, the new House may vote to repeal the Obama health plan, which is unlikely to fly in the Senate. On the off chance it did, the President would veto it. Instead, expect bipartisan approval of must-have legislation such as increasing the debt limit and passing appropriations bills. Beyond that, don’t expect much. Meanwhile, since the US business cycle will, we think, successfully transition from recovery to expansion in 2011, more fiscal policy stimulus—improbable, given the new Congress—won’t be required. In turn, that will keep monetary policy stimulative longer than would have otherwise been the case.

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