Global Equity Strategy
June 30, 2015
Sean Lynch, CFA®, Co-Head of Global Equity Strategy
Analysis and outlook for the equity market
- Equity markets experienced heightened volatility this week— with a possible Greek exit from the Eurozone, and Chinese local markets suffering a 20 percent correction in the past two weeks.
- This volatility may lead investors to question their exposure to global equities.
What it may mean for investors
- We believe that investors should be patient, remain focused on fundamentals and avoid trading on Greek headlines. European disappointments could create a buying opportunity for investors who are underexposed to international developed-market equities.
- Poor underlying earnings growth in emerging markets and possible reform and policy missteps in coming quarters make us hesitant to build incremental exposure to emerging markets.
When Stocks Disconnect from Fundamentals
It has been quite a hectic week for global equity markets—with the sharp fall in Chinese equities and the looming prospects of a Greek exit from the Eurozone. Events like those of the past week are prime examples of equity markets detaching from fundamentals. In both cases, these events should not have completely blindsided markets—and yet their arrival has resulted in heightened volatility and increasing questions from investors. Event-driven markets can be a good way for investors to assess their ability to withstand volatility and commitment to maintaining their diversification. They can also offer opportunities. In this Global Equity Strategy Report, we review the equity market ramifications of the possible Greek exit from the Eurozone as well as recent developments in China.
Greece seems to be on the brink of exiting the Eurozone. Equity markets across the globe declined on Monday as Greek banks were closed and will remain so for the remainder of the week. (The June 29 Global Macro Strategy report titled “It’s All Greek: What has changed in the Greek crisis, and what to do about it” provides more information on Greece.) The equity-market decline on Monday was followed by more muted action on Tuesday. That may be because investors are still skeptical that Greece will actually exit the Eurozone—but the odds that it will do so have definitely increased. However, it is important to note that Greece’s current partners in the currency bloc— namely, Germany, France, and Spain—are in a much different economic position than Greece. Just last week, the Eurozone composite purchasing manager’s index came in at 54.1.1 This is a multi-year high and clearly shows that the economy is picking up momentum in most parts of Europe.
This economic growth should eventually translate into better corporate profits and help push equity markets higher. European equity markets already have experienced strong gains over the past six months in the face of the Greek uncertainty. Even after Monday’s losses, the German DAX Index has risen 13.0 percent and the French CAC 40 Index is up 14.0 percent in local terms to date in 2015.2 Earnings estimates have been revised upward and valuations remain reasonable. Developed markets currently trade at 17.5 times our 2015 earnings estimate. While this is slightly above the long-term average, we believe that market gains going forward will be fueled by earnings growth and improving fundamentals, rather than by expanding price-earnings ratios.
We are worried that the disruption in Greece will cause investors to become overly cautious, especially if the Greek crisis is drawn out over months. However, we do believe that the risks are likely to be contained to Greece and smaller, peripheral countries in the Eurozone. We also believe that the European Central Bank’s program to aggressively buy regional bonds should limit the extent of financial contagion and maintain the Eurozone’s recovery. U.S.-based investors may be worried that the return of a weaker euro currency in the wake of the Greek tensions will eat away any excess returns they may experience. However a weaker euro also will improve the competitiveness of many exporters in the Eurozone. The benefits that a slightly weaker euro will bring to earnings and hence future market gains should outweigh the impact of U.S. dollar translation concerns.
China’s Bull and Bear Market
If Greece weren’t enough for global investors to digest, China also is grabbing headlines as the Shanghai Composite Index has entered bear market territory— falling 21.5 percent since its high on June 12.3 Following our visit to China earlier this year, we noted the puzzling aspects of an economy seeing a deceleration in its growth rate, while some of its equity markets register tremendous gains. Chart 1 shows that Chinese leading economic indicators (as measured by the China Leading Index) have been declining while its equity markets have been rising. Despite the steep declines of the past two weeks, the Shanghai Composite Index is still up 25.3 percent for the year and 97.8 percent over the past 12 months.4
Chart 1: China Leading Index vs. Shanghai Composite Index
Source: Bloomberg, 6/26/15 Past performance is not a guarantee of future results.
China’s equity-market decline has occurred in holdings that are mainly accessible to mainland China investors. The Shanghai Composite and Shenzhen Composite indices shown in Chart 2 are examples. These “A” share markets trade in yuan and saw huge inflows of local investor money over the past year. Chinese officials have had a delicate balancing act of reigning in excessive speculation and debt in local markets without severely hampering a national economy that has been trying to stabilize. Over the weekend, the People’s Bank of China (PBoC) cut rates as another mini-stimulus measure to improve the economy. The longer-term combination of mini-stimulus measures by the PBoC, meaningful reforms, and opening access to equity markets may attract more longer-term-focused investors and money managers. Until then, these markets seem to be driven more by momentum and money flows than by fundamentals.
Chart 2: Chinese Composite Equity Indices: June 2014 to Date
Source: Bloomberg, 6/26/15 Past performance is not a guarantee of future results
In the long run, equity markets should be driven by company fundamentals, interest rates, and the long-term forecasts for underlying economies. In the near term, politics, momentum, and fear can all whipsaw equity markets. We do not believe that developments surrounding Greece portend that the economic recovery in the Eurozone is about to roll over. Further, we also believe that the huge rise and subsequent fall in local Chinese equity markets have more to do with money flows and investment access than with long-range planning and equity-market prospects in China. We continue to believe that investors should be overweight international developed equities. We are mindful of the risk of contagion from the Greek crisis in Europe, but, as noted, we believe that it can be contained. Investors may have an opportunity to build their developed-market equity positions at attractive valuations if markets overreact to developments that follow the current crisis in Greece. With respect to China and emerging markets, we remain more cautious. China now represents nearly 25 percent of the major emerging-market averages. Most active managers have been underweight China, and this may help them in the coming quarters. However, we believe that China and other emerging markets still need to deal with poor underlying earnings growth and possible reform and policy missteps in coming quarters.
Weekly Wrap and Look Ahead
Most major domestic and international indices were negative for the week, but all were positive year to date.
|Index||Last week's performance1||2015 YTD performance|
|MSCI Emerging Markets||+0.9%||+3.8%|
1 For the week of June 22 – June 26, 2015
Sources: Wells Fargo Investment Institute, Bloomberg, 6/26/15
Past performance is no guarantee of future results. Indexes are unmanaged and not available for direct investment.
Five of 10 S&P 500 sectors outperformed the Index but only three of 10 managed to gain ground for the week.
|Best Performing Sectors||Last week's performance2||Worst Performing Sectors||Last week's performance2|
2For the week of June 22 – June 26, 2015
Sources: Wells Fargo Investment Institute, 6/26/15
Past performance is no guarantee of future results. Indexes are unmanaged and not available for direct investment.
In the coming days, investors will see many headlines concerning Greece as it appears there will be a vote by the citizens of that country on July 5 to either accept or reject their creditors’ proposals. While virtually all polls are showing that more than 55 percent of Greek citizens are willing to accept creditor conditions to get the financing needed, stock markets around the world are nervous and uncertain.
The first three days of the trading week will focus on Greece, but the final trading day, Thursday, will feature reaction to the U.S. employment report covering June. Remember, the financial markets are closed on Friday, July 3, in recognition of the Fourth of July celebration on Saturday. Given the long weekend and the Greek vote on Sunday, we expect most traders and short-term market timers to square positions before leaving the office on Thursday. This fact may add to downside market volatility even if the polls show a positive (“Yes”) vote on accepting the proposed creditor conditions.
We expect Thursday’s employment report to show that approximately 230,000 net new non-farm payroll jobs were added in June. The unemployment rate is expected to drop slightly to 5.4 percent. We continue to look for the labor market to slowly improve and expect to see slightly more wage pressure (in terms of average hourly earnings) in coming quarters. However, we are not looking for hourly earnings to increase at the Fed-favored pace of three to four percent on a year-over-year basis any time soon. Hourly earnings rose at a 2.3 percent annual rate for the 12 months ending in May.
|Sector||S&P Weighting*||Wells Fargo Investment Institute Guidance|
|S&P 500 earnings estimate for 2015||$128.00|
|S&P 500 year-end 2015 target range||2,150-2,250|
*Sector weightings may not add to 100% due to rounding. Weightings as of 6/29/15 close.
Sources: Wells Fargo Investment Institute, Bloomberg, 6/29/15.
1 Bloomberg, 6/29/15.
2 Bloomberg, 6/29/15.
3 Bloomberg, 6/29/15.
4 Bloomberg, 6/29/15.
Sean Lynch is the co-head of global equity strategy for Wells Fargo Investment Institute (WFII), an organization that provides global manager research and investment strategy advice to Wells Fargo’s Wealth, Brokerage, and Retirement (WBR) division. WBR is comprised of Wells Fargo Private Bank, Wells Fargo Advisors, Wells Fargo Institutional Retirement, and Abbot Downing businesses, accounting for more than $1.6 trillion* in assets under administration.
In his current role, Mr. Lynch is responsible for developing global equity strategy and oversees proprietary equity strategies as well as the equity trading desk. He has represented Wells Fargo to the media on numerous occasions, providing insights and perspectives on the global markets. He has also written extensively about global issues and the implications on client portfolios, appearing in Bloomberg, The Wall Street Journal, USA Today, Money, and on CNBC.
Mr. Lynch has been with Wells Fargo for 17 years. Prior to his current role, he served as a global investment strategist for Wells Fargo Private Bank. He has traveled extensively internationally—from Asia to South America to Europe—to gather firsthand knowledge and information, and has shared his observations and perspectives with clients and team members. He has been in the investment management and trust industry for 24 years.
Mr. Lynch earned a Bachelor of Science in Business Administration, specializing in Accounting and Finance, from the University of Nebraska-Omaha. He is a CFA® charterholder and a former president of the Omaha-Lincoln Society of Financial Analysts. Mr. Lynch is located in Omaha, Nebraska.
*As of Sept. 30, 2014
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
Indexes are unmanaged and not available for direct investment.
The China Leading Index provides a measure of leading economic indicators in China. The components used to calculate this leading indicator include: Hang Seng Mainland Freefloat Index, industrial sales, M2 money supply, new fixed asset investment, logistics index (total freight traffic and volume of transportation in major harbors), real estate investment (land and construction of residential properties), consumer expectations index and a measure of yield spreads.
The ChiNext Composite index is comprised of higher-growth, high-tech companies and other holdings. It is similar to the NASDAQ Index in the United States, but is located in China. ChiNext was founded on October 23, 2009.
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq.
The French CAC Index is a benchmark French stock market index. The index represents a capitalization-weighted measure of the 40 largest stocks among the 100 highest market caps on the Euronext Paris (formerly the Paris Bourse).
The DAX German Stock Index represents 30 of the largest and most liquid German companies traded on the Frankfurt Stock Exchange.
MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
NASDAQ 100 Index is an unmanaged group of the 100 biggest companies listed on the NASDAQ Composite Index. The list is updated quarterly and companies on this Index are typically representative of technology-related industries, such as computer hardware and software products, telecommunications, biotechnology and retail/wholesale trade.
Russell 2000 measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. The Index is unmanaged and not available for direct investment.
The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990 with a base value of 100.
The Shenzhen Composite Index is a market-cap weighted index that tracks the stock performance of all the A-share and B-share lists on Shenzhen Stock Exchange. The index was developed on April 3, 1991 with a base price of 100. Index trade volume on Q is scaled down by a factor of 1000.
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