Outlook 2013 With Mr. X: Part Two

Macro Research | BCA | Independent Economic ResearchIn this edition of Q & A with BCA, we are pleased to offer a recent question posed by long-time BCA client, Mr. X.  Making his first appearance in 1962, Mr. X has visited our offices at the end of each year to discuss the outlook for economic and financial markets. Please find below the second installment of our five-part series recapping our December 2012 meeting.

Mr.X  Your view makes me uncomfortable given that I regard monetary policy as being excessively easy. I need more fundamental reasons to be in equities and corporate bonds other than just because low interest rates are forcing everyone to take on more risk. That sounds like a greater fool theory environment and one that could unravel badly.

BCA  The case for overweighting equities is not just about QE and low interest rates. On their own, those would indeed be poor justifications for taking on risk. The more important reason is that corporate finances are healthy in many of the major economies. And where earnings are not doing well, that generally is fully reflected in valuations. As long as earnings hold up, then equity should grind higher over the coming year.

It also is worth noting that we do not have the bullish investor sentiment that typically signals a top in the market. Surveys indicate that only around 40% of advisers and individual investors are bullish on stocks.  Typically, this rises to around 60% at peaks. The issues that worry you also continue to trouble many other investors.

We should stress that we are not looking for huge stock market gains: total nominal returns of around 6% a year over the medium term seems a reasonable expectation for a global equity portfolio, and almost half of that will come from dividends. So this warrants modest rather than aggressive overweight equity positions. And the same logic applies to corporate bonds.

A more bearish stance on risk assets would be warranted if one or more of the following conditions were met: earnings suffered a major setback, interest rates spiked higher or valuations were at an extreme.

Either deflation or significant inflation would be toxic for stocks: the former would be very bad for earnings while the latter would signal the end of accommodative monetary policies. For at least the next couple of years, we expect to walk a fine line between these two extremes.

Beyond that, the picture gets murkier, although, as we noted earlier, a sustained outbreak of inflation seems unlikely unless it was preceded by a nasty bout of deflation.

Stay tuned for more on this five part Q&A series with Mr. X!


The Importance Of Equity Buybacks

The backdrop is constructive for U.S. stock repurchases this year, which will boost EPS growth. Nonetheless, the key to sustaining the equity bull market is growth, not buybacks.

Importance Of Equity Buybacks

T he net withdrawal of equity has been fairly large since the end of 2010. Our rough proxy for the historical impact of equity withdrawal suggests that buybacks have boosted EPS growth by 2 percentage points in the year to 2012 Q3. It would not be surprising to see a similar or higher contribution to EPS growth in 2013.

But, do buybacks tell us anything about the economy or profit cycle apart from their mathematical impact on EPS?

Note that a surge in share buybacks generally occurs when economic activity is robust, but buybacks are not a leading indicator for the economy. Equity retirements typically ramp up only after real GDP growth has risen above a trend pace, and quickly fall off when growth drops below trend (about 2½%). As such, buybacks are more of a reflection of the economic and financial landscape.

…the key to sustaining the equity bull market is growth, not buybacks. (tweet this!

Relative prices and the capital structure matter as well.

As theory would suggest, corporations tend to leverage-up when corporate equities are undervalued relative to bonds. Our Capital Structure Preference Indicator highlights the strong incentive for firms to issue bonds and buy back stock at the moment. While buybacks can have a meaningful and immediate impact on EPS, it is difficult to observe the effect they might have on bottom-up earnings estimates for the future, because any relationship is masked by the economic cycle.

The key to sustaining the bull market is growth. Buybacks won’t save the day if underlying profit growth stagnates again in 2013 as it did in 2012.

Fortunately, the signs are pointing to a better year ahead.

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