2013 global equity outlook: Searching for alpha in a stock picker s market

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1 March global equity outlook: Searching for alpha in a stock picker s market Saira Malik, Head of Global Equity Research, TIAA-CREF Executive summary The outlook for equity markets is favorable for 2013, as positive economic momentum should support further price appreciation. Two powerful trends are driving markets: equity cross-correlations have fallen; and Main Street investors are rotating back to stocks after several years of de-risking. Current stock market valuation and positive economic indicators should support further expansion of corporate earnings and equity prices in U.S. tax increases and government spending cuts will serve as headwinds to economic growth, although neither will likely derail the economy. There are opportunities in international developed and emerging markets, including in Japan and China, both of which have new governments and economic policies. A good sign for stock pickers: Equity correlations have fallen Active stock pickers have faced challenging conditions over the last five years, as markets have been volatile and heavily swayed by macroeconomic events such as the eurozone crisis, China s economic growth, and the fiscal debate in Washington D.C. Instead of choosing individual stocks based on their underlying fundamentals, investors tended to trade the asset class as a whole. We observed this phenomenon through elevated equity cross-correlations, which rose during the financial crisis of 2008 and peaked in November 2011, and have been declining since. Uncertainty over some of these larger macro issues have been addressed to one degree or another over the last several months, though none have been solved. As a result, volatility has declined and correlations have recently hit a five-year low. We are beginning to see better opportunities emerge for stock pickers to generate alpha, or benchmarkbeating returns.

2 Figure 1: Correlations have decreased since 2011 Median correlations of individual S&P 500 stocks to the S&P 500 Index* *Median 252-day rolling correlation of 1-day returns. Source: Ned Davis Research, Inc. Equity flows swing from negative to positive in 2013 Main Street investors, who have shunned stocks over the last five years, started rotating back into stocks this year. About $38 billion flowed into equity funds, ending ten straight months of outflows. Flows continued to be positive through February and early March, though retail investors are still allocating significant amounts to bond funds. Outflows from equity funds have created a drag on the equity markets even as they have rallied and doubled in value off of their March 2009 lows. A reversal of flows can create a tailwind for stocks, though it is difficult to predict whether the trend will continue. Figure 2: Strong flows into equity funds in early 2013 Strong equity flows this year reversed 10 months of outflows Source: Ned Davis Research, Inc.

3 A three-legged stool helping the economy: Housing, jobs and manufacturing Strong economic momentum in the housing, jobs and manufacturing sectors should provide an underpinning for further stock market price appreciation this year. The housing market, for example, has been a laggard during the current economic recovery, and a reason why the recovery has been the weakest in the post-world War II era. Housing typically leads the economy after recessions, posting strong gains and driving growth. We are seeing a turnaround, however, as there have been many positive developments in housing. We ve had six consecutive quarters of housing start gains, for example, and there is room here for more growth. Housing prices are also improving, up about 5.5% over last year. Rising home prices produce a consumer wealth effect, which may lead to greater spending. Figure 3: Wealth effect supports consumer confidence and spending S&P Case-Shiller Home Price Index 20-city composite, % change from a year ago, through December 2012 Source: S&P/Case-Shiller The labor market has also lagged for much of the recovery since 2009, causing additional concern for consumers. A key labor market indicator is the four-week moving average in first-time unemployment claims. This figure peaked at around 660,000 in March 2009 or the height of the Great Recession, but since then has been edging down. When the average dips below 350,000 it signals an expanding economy. The four-week moving average was approximately 339,000 through the first week of March, which indicates that the slowly healing employment picture is helping the economy gain momentum.

4 The third leg of the stool is expansion of manufacturing activity, which has mostly been in expansion territory since the end of June A key indicator to watch for manufacturing health is the Institute for Supply Management s Purchasing Manager s Index, a monthly figure that shows whether the sector is growing or contracting. Manufacturing activity has stayed in expansion territory over the last several months. Equity valuations still look attractive Considering strong equity flows, an improving economy and headline-grabbing stock market highs, some may wonder if the current rally has peaked. We believe it has legs, as economic momentum in key sectors should continue and as equity valuations continue to remain below long-term averages, as shown in Figure 4. The median price/earnings ratio for the S&P 500, for example, was a little under 16 in early March, which compares favorably to its 20-year average of about Figure 4: Stock market valuations still attractive Valuations and economic indicators support further earnings expansion Source: FactSet *Data through February 2013 Risks to the current rally: What could go wrong? There are risks to the current rally, including uncertainty surrounding fiscal policy, higher taxes, rising gas prices and shaky consumer confidence, among others. Gas prices have increased by 12% over the past few months, and a sustained increase can reduce economic growth. It also has the further negative effect of dampening consumer confidence, which may explain why confidence remains mixed in the midst of positive economic news of late. Higher taxes and U.S. federal budget cuts are problematic but temporary, which may be a silver lining. Economic growth is projected to slow during the second and third quarters this year, but we don t expect the net effect on the overall economy to be too damaging. We expect the budget cuts, or sequestration in Washington lingo, will reduce GDP by about 0.5%, but that overall growth for the year should be between 2%-2.5%.

5 Europe: A different story Europe remains problematic as economic activity continues to contract and European Central Bank (ECB) stimulus measures haven t done much to stimulate growth though they have allayed fears of a euro breakup. The ECB s forced austerity measures, for example, are dampening prospects for growth yet if troubled countries don t adopt austerity, the financial system cannot stabilize. Figure 5: Eurozone still in recession Growth remains negative due to slow recovery from debt crisis Source: Eurostat A lack of global shocks could help Europe to get back on its feet, in addition to favorable resolutions in some of the troubled economies such as Italy and Cyprus. Companies showing strong profitability growth and cash characteristics, should be positioned well should these macro issues continue to impact the eurozone. Japan: A hot market in 2013? Japanese equities have outperformed early in 2013, as policies under new Prime Minister Shinzo Abe have sought a weaker yen. A weaker currency can boost corporate earnings and improve a country s economic competitiveness by reducing the cost of exports. Japan s Nikkei 225 index outperformed all major equity indexes around the globe in the first quarter, gaining 19.3%. It was also the index s best two-quarter advance since Japanese equities have lagged for years even domestic investors have kept their savings primarily in cash vehicles. The recent turn of events there has been interesting, but successful policy execution on fiscal stimulus, deregulation, and structural reforms are critical to take Japan to the next level.

6 Emerging markets: Underperforming The largest emerging markets have experienced lower GDP growth (although still strong) in recent quarters, rising inflation and poor execution on policy issues. China s GDP growth, for example, while still strong at 7.9% during the fourth quarter of 2012, has slowed from the days of double-digit quarterly gains. The government has also sought new policies to stimulate growth. China s government has historically used fixed-asset investment as an economic growth engine, but has recently sought to transform to a consumption-driven economy. China also may be facing an inflation problem inflation was 3.2% in February, compared to 2% the month before. Figure 6: Emerging market equities underperformed in Q S&P 500 MSCI EAFE MSCI EM MSCI BRIC Source: FactSet, as of March 31, 2013 It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs. Conclusion: Many risks, but we remain optimistic There are many events in motion, and any one of them has the potential to derail or at least threaten the current rally. Key spending and taxation issues, not to mention the debt ceiling, are still on the table in Washington D.C. An unexpected exit from the eurozone, or a North Korean attack are examples of tail risk events, or statistically unlikely but possible events that could pose a major shock to the system and change the outlook for equities. We view both scenarios as low-probability events, but there always exists the potential for an unforeseen event to affect markets. We remain optimistic on equities for several reasons: There are strong economic underpinnings supporting the market, including housing, labor and manufacturing. Macroeconomic shocks are decreasing. Stock market valuations remain below average. The strong equity market rally is causing a wealth effect for investors.

7 Main Street investors are buying stocks once again, as stock mutual funds reversed 10 straight months of outflows in January. Conditions continue to improve for active stock selection, and markets are once again rewarding company fundamentals instead of trading the entire asset class. Overall, while there are still risks to consider, conditions for equities are positive for We believe that the latest rally has room to run, as stock market valuations are below their long-term averages and as the economy continues to gain momentum, although there remains potential for a short-term correction. More importantly, we re encouraged by trends that indicate improved conditions that should reward fundamental, research-focused stock selection. C10088 The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance does not guarantee future results. Please note equity investing involves risk. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA ). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA) Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY _ (04/13)