Why Slow Growth Is Good for Stocks

By LAWRENCE C. STRAUSS | MORE ARTICLES BY AUTHOR

J.P. Morgan Global Strategist Jan Loeys sees mediocre economic growth but strong corporate-profit gains. Bullish on small-caps and emerging markets.

 

Equities have had a big run in the past two years, with the Standard & Poor's 500 just about doubling from its March 2009 low. But Jan Loeys, global strategist at J.P. Morgan, thinks stocks still are the best game around, particularly compared with bonds, which sport paltry yields now that prices have been bid up. Loeys, who began his career at the bank in 1986, notes that the current low-growth economic environment is beneficial to corporations in that they don't have to increase spending significantly on salaries and wages. Thus, he is bullish on stocks but cautious on economic growth, which he says will improve slowly in the second half of 2011 and 2012.

Barron's recently interviewed Loeys, 58, by telephone to hear more about his take on the economy and financial markets. Our conversation began while he was in Singapore, and continued after he arrived in Europe, evidence of a peripatetic career that has given him a global perspective.

Barron's: You travel the world for business. How does the global economy look?

Loeys: Global economic growth will be mediocre, held down by continued balance-sheet repair in economies where leverage had gotten out of hand. That's on the household and banking side in the U.S. and U.K., and among smaller governments in Europe, such as Greece and Ireland. We see global economic growth of around 3.2% this year and 3.6% next year. Inflation is still mostly under control.

Where are there signs of strength?

We are now at the second anniversary of the global recovery that started in the middle of 2009. There are several factors to consider. First, unemployment is high, and as a result, wage growth and the cost of borrowing are low. Both factors strongly support corporate profitability.

Gary Spector for Barron's

"Shifting cyclical exposure from credit to equities is the largest change we've made in six months." ―Jan Loeys

We have seen a massive increase in profit margins, and the growth isn't over. For the U.S. in particular, we are projecting that the growth of overall economic profits, based on the national income account, will slow, but still be about 10% per year for this year and through 2013. That's relative to nominal GDP [gross domestic product] growth of about 5%. So profit margins have increased to near-historic levels. That provides strong support for both equities and corporate credit. This is different from previous expansions because major central banks―in Japan, Europe including the U.K, and the United States―will maintain very low interest rates. That will keep the return on cash close to zero. We are significantly overweight equities, relative to debt and cash.

Where do you see the best opportunities in equities?

We are overweight emerging markets versus developed markets, and the U.S. versus Europe. I am turning positive on cyclicals versus non-cyclicals, and I have a preference for small-cap and growth over large-cap and value. I favor emerging versus developed markets because of the already-significant growth gap between emerging and developed markets. The historic growth gap is about three percentage points, which is now widening to about four percentage points. Emerging markets do not have many of the problems of developed markets, in particular the post-financial-crisis deleveraging. Emerging markets had their own crises from the late 1980s through the late 1990s, but they learned from those crises by cleaning up their balance sheets. As a result, emerging markets are going through a significant growth phase.

Although that may seem like a consensus view, it isn't, in that a lot of investors got out of emerging markets at the beginning of this year and went into developed markets on the fear of overheating in China and inflation getting out of control. Inflation in China and other emerging markets is about to peak. We are moving to a pause in, not an end of monetary tightening in those markets. That will make emerging-market equities perform strongly relative to developed markets in the next six months.

What are your other equity weightings, starting with the U.S. versus Europe?

We are overweight the U.S. versus Europe due to the beneficial impact of a cheapening dollar and the lack of monetary tightening in the U.S. Growth stocks have better momentum than value, and the category doesn't include as many financials, which remain under the cloud of increasing regulatory burden and restrictions on their profitability. Our preference for small-caps is largely a call on momentum and higher beta. Small-caps tend to perform better than large-caps early in the cycle.

Besides favoring equities over fixed income, what are some of your other preferences among asset classes?

Within fixed income, we have a modest overweight in corporate and emerging-market sovereign credit versus U.S. Treasuries. Within the U.S. debt markets, we have a strong preference for banks over non-financials.

Why is that?

There are two reasons. Relative to the past, bank debt broadly is trading at higher yields than non-financials. Secondly, while major regulatory changes are depressing banks' profitability, they are having a strongly positive impact on banks' credit quality. The very large increases in bank-capital requirements and the reduction in risk banks are taking are significantly increasing the safety of banks. And there is the good credit quality of their debts. So when overweighting banks, one should do it in credit rather than equities.

What is your view of the dollar and other currencies?

We are bearish on the dollar, but not simply against the euro or the Japanese yen, as we don't have a strong view on those. We have a call on the G6, however, versus what we call the G4. The G4 are the four largest markets: the U.S., the euro area, the U.K. and Japan. All have low growth, high budget deficits, low interest rates and, as a consequence, very low returns on cash. We prefer countries that have stronger growth, almost no budget deficits and significantly higher returns on cash. We call these smaller developed markets, including Canada, Switzerland, Sweden, Norway, Australia and New Zealand, the G6. We like their currencies more than those of the G4. For U.S.-based investors, we prefer those currencies to dollars.

Are you bullish on commodities?

We have a modest and selective long position for the next year. These aren't short-term trades. Part of the commodity world has significant supply-demand imbalances, due to supply constraints. That includes crude oil although not natural gas. It also includes copper and gold. All three also are in strong demand, so we advise owning crude, copper and gold.

What are some key changes you have made this year in your asset-allocation recommendations?

The most important one is that we have downgraded, over time, the overweight of credit. We had a significant, aggressive overweight of many credit products through early this year. We maintain a slight overweight in credit, but much less than before, given how much credit has rallied already in this cycle. It is our judgment that at this point in the cycle, a significant part of the credit rally is behind us, while a significant part of the equity rally is still in front of us. Shifting cyclical exposure from credit to equities is the largest change we've made in the past six months.

Within the credit market, how do you view high-yield debt?

It is going through a correction. High-yield had been the truly preferred asset class of many investors, in that it had the advantage of yield, and not the volatility of equities. Given that high-yield touched a new all-time low in yield a few weeks ago, it probably can't be called high-yield anymore. So the upside is now more limited. For the rest of the year we expect to clip our coupons on high-yield, but not to get capital gains from here.

What is your advice to individual investors regarding asset allocation?

No. 1: Let value dominate fear and greed. The medium-term investor―someone investing for the next six to 12 months―too frequently focuses on assets that have been rallying and anticipates that the rally will continue. The medium-term investor needs to replace that approach by looking at the value of the assets. Where is the strong growth? Where is there high income? Don't be dominated by fear of near-term events, including the debt-ceiling discussion in Washington and what is going on Europe.

My preference for equities is driven primarily by the fact that they are cheap relative to fixed income and cash. It's not that equity multiples are that low relative to their history. But the investor needs to recognize that when a Treasury bond has a 3% yield, its expected return is 3%, which is barely above the dividend yield on equities. So it is important to pay more attention to value and expected growth in economies than recent price action.

Speaking of the debt ceiling, what do you see happening with the standoff in Washington and the financial crisis in Greece?

They are similar and different at the same time. The U.S. debt ceiling is not the real issue. The real issues are that the deficit is too large, the debt keeps growing and the U.S. is on an unsustainable fiscal path. Everyone in the country knows that either taxes need to be raised significantly or spending needs to be cut, or there needs to be a combination of the two. We know that inaction is not permitted. Ultimately a compromise needs to be reached across the political spectrum in order to maintain the credit quality of the U.S. government. It is to the advantage of nobody to let that slip. So the debt ceiling is just part of the ongoing battle between different opinions on that issue, and it is quite possible that we will have to wait until the presidential election next year before somebody receives a clear mandate.

And the situation in Europe?

Europe as a whole is solvent. It doesn't have a higher debt load than the U.S. In fact, it has a lower deficit. However, it needs to properly operate as a single country, as it already has a single currency and is in the midst of a debate about how to bring about further integration. The issues for Europe are more existential than for the U.S. Failure to resolve how to further integrate and promote an economic and fiscal resurgence in Europe will lead to disintegration. We will see a lot more back-and-forth discussions within Europe. Ultimately the crisis in Greece is forcing Europe to integrate Germany further with the rest of Europe. The final decision in Europe will take longer than resolving the debt ceiling in the U.S.

In one of your notes, you wrote about expecting a reacceleration of growth. Could you elaborate?

We have had a slowdown in the first half of the year, largely in the U.K. and the U.S., combined with collapse in Japan, due to the tsunami in March. When we talk about reacceleration, it is probably the wrong word. We are going from a below-average pace to an average pace of growth. It isn't fast at all. We are going through an inventory cycle in global industry. Too much inventory was produced earlier in the year, creating a glut. Now we are eliminating some of the excess inventories that were built up, and weather conditions are improving. The negative impact of the Japanese tsunami is turning around. All this should help produce a modest return to average-type growth, which means about 2.5% for the U.S this year. This is a gradual movement away from very slow growth earlier in this year.

What most concerns you about the second half of the year?

Two risks stand out, and both related to the deleveraging brought on by the financial crisis. One is the U.S. consumer and the second is the European periphery―governments such as Greece and Portugal. One should worry whether both will be allowed to repair their balance sheets at a controlled pace, or be forced―or decide themselves―to accelerate the deleveraging process. Accelerating it would threaten economies and pose a risk to markets.

U.S. households are making rapid progress in reducing debt through saving and debt forgiveness, but fear about the future could induce them to go faster. If that happens, the widely expected rebound to 3% economic growth won't happen. In Europe, the threat to the economy comes from investors fleeing the periphery countries before policy makers have put together a credible plan for funding these countries.

Overall, it sounds as though you are cautiously optimistic. Is that correct?

It depends on what we are talking about. I am realistic on growth because the U.S. and other countries like the U.K. are in a multiple-year period of recovery. That's due to the need for balance-sheet repair, both at the household and at the public-sector level, so we are not going to have strong growth for the foreseeable future. We are in a sustained period of weak growth. As for markets, corporations have very strong profitability and the alternatives to equities such as cash and government debt offer no yield to speak of. So I'm very optimistic on equities, but not on growth. For the S&P 500, I'm going to use the same forecast as Tom Lee, our U.S. equity strategist. His year-end target is 1,475, versus around 1,330 recently. That would be a low double-digit return of around 11%.

Thanks, Jan.