Triumph for Equity Markets!

• Yet here we are again, with the Dow having breached 13000. Of course the rise in the US equity market since last October pales in comparison with the dazzling performance of a number of other indices like the Shanghai Composite. That index has doubled over the past six months.

• But while China along with India and various other emerging markets represent the new economic frontier, financial markets still look to the US for leadership and, symbolic though it may be, the Dow provides that leadership. It is highly visible and widely recognized and in moving through 12000 and now 13000, the message to investors in global equity markets has been to stay the course.

• And so they have - despite the tightening bias in central bank policies and despite the slowdown in earnings growth. On the latter, earnings growth is actually proving to be better than expected pretty well everywhere, although in the case of the US, one wonders who’s been kidding who!
  

• At the start of the year, the consensus expectation for first quarter US earnings growth was 8.7 percent. By the time the results season got under way, that estimate had been cut to 3.3 percent. Around 60 percent of the S&P 500 has now reported and, according to Thomson Financial, earnings are growing by over 7 percent and that number has been rising. What encouraged the analysts to be so savage with the knife? Were they misled by the guidance from companies?

• When all’s said and done, the outcome for first quarter US earnings is likely to be closer to the expectation the consensus held at the start of the year, namely the 8.7 percent.
  

• However, it’s all academic. While the analysts may have taken too much heed of what companies - or their strategists - were telling them, importantly, the equity market chose to take no heed at all. The Dow, the S&P 500 and Nasdaq knew better and stayed the course. Their view has been: okay, so earnings growth is slowing. The high double digit growth rates of the past four years are unsustainable anyway. What’s wrong with something in the region of 5 to 10 percent, i.e., the kind of earnings growth that is consistent with what corporate America has delivered over the long run?

• Where to for equity markets now? Is the Dow’s lead indicative of a momentum that can be sustained? Here’s the bull case.

• Our sense is that global equity markets regard monetary policy as still largely accommodating. Sure interest rates are going up, but so are forecasts for economic growth. The expectation that earnings growth will accelerate later this year is justified by the positive growth surprise in the global economy and the upward revision in consensus forecasts for GDP growth.

• Also, valuations are still reasonable. As we’re used to saying, equity markets are not cheap but they are not expensively rated, thanks to the large caps, which have experienced some de-rating. That’s one reason why equity markets have not come to any harm. Set backs have proved to be buying opportunities. The valuations remain supportive.

• Corporate activity remains aided and abetted by the strength of the global economy. Higher interest rates are a risk but, provided interest rates don’t rise much further, there is considerable scope for the corporate sector to take on any leverage required to finance bigger and bolder acquisitions.

• According to UBS Investment Research, the ratio of net debt to equity in the major markets has continued to fall. Five years ago, the ratio stood at 65 percent. Last year it stood at just over 40 percent and this year it is expected to fall further to around 32 percent.

• Bigger and bolder acquisitions could inject a bit of bid premium into the large cap segment of the equity markets. That would arrest the de-rating and help the performance of the large caps. Whether they would outperform the second liners, is another matter, but it would sure help sustain the momentum underlying the global equity markets.

• The positive growth surprise in the global economy and the upward revision in consensus forecasts for GDP growth mean that interest rates aren’t yet restrictive. That may be because of the long and variable time lags, in which case the central bank tightening thus far may eventually prove restrictive. It has already in the US given the weakened state of the housing market and the sub-prime mortgage market. Outside the US, interest rates are heading higher.

• Higher interest rates are the key risk for equity markets and the main bear point. Higher rates can turn valuations that look reasonable into valuations that look unreasonable. They can bring corporate activity to a standstill. Indeed, higher rates render vulnerable any form of leveraged activity.

• While interest rates are heading higher, our view is that they are not heading a whole lot higher. In the US we’re talking about the Fed maintaining the Funds rate at 5.25 percent. If the growth of employment falters, say because of poor growth in profitability and investment, the Fed will cut, but not before. In the UK and the eurozone, we see policy rates at 5.75 percent and 4 percent max respectively. In Japan, the BoJ may want to raise rates but can’t, really, until the trend of inflation picks up and that’s not likely for some months.

• On balance, we reckon there is more going for the bulls than the bears. We expect the Dow to continue to hit new highs before year-end. That will help sustain the positive momentum underlying the global equity markets and take them to new highs by year-end.

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.