The big investment question for 2010 is to what extent can businesses start to generate earnings, apart from the massive amount of stimulus that has been pumped into the economy. According to two seasoned forecasters, the outlook is good.
It’s highly unlikely clients are going to see a run-up in stock prices like that seen since the market lows of March, but modest, steady earnings growth is a possibility, says Norman Raschkowan, the chief investment officer at Mackenzie Investments.
“We expect economic growth will be relatively modest as opposed to the 6%-plus rate of growth North American economies usually experience coming out of the recession. The consumer is still bearing the brunt of having too much leverage on their personal balance sheet,” Raschkowan says. “Consumers are not going to be the drivers of the economic recovery the way they have in the past. We think that businesses are going to find the cost of financing inventories will remain punitive — they are not going to be inclined to build inventories the way they have after past recessions.”
Raschkowan says this means returns on North American stock returns will likely start to resemble their historical average, versus the roller-coaster returns of the past couple years.
“The bad news is you’re not going to see the surge in corporate profits that you would expect in your first year of recovery. We’ve seen some very nice improvement in the profitability in the second and third quarter. That’s been largely driven by cost-cutting, whereas revenue growth has been relatively disappointing,” he says. “You’re starting from a position of fair value, and you’re looking at relatively modest earnings growth over the next three years.”
He says investors can expect a 3% dividend yield on the market, plus capital appreciation of between 6% to 9%.
According to Patricia Croft, the chief economist at RBC Global Asset Management, sustainability is the primary risk facing investors. If the recovery is sustainable, then stock earnings should continue to grow.
“I think it is indisputable that we are in an economic recovery, but the question of the sustainability of this recovery is still an issue as we head into 2010. One of the big questions going into 2010 is whether this recovery can stand on its own two feet or is it just about [stimulative] policy,” she says. “I think the answer will become clear as we go through 2010. We will be able to assess on a three- to five-year time frame whether the recoveries are sustainable or not.”
She adds, “We are overweight stocks within our asset allocation strategies, again positioned in a recovery. We think the possibility of a double dip — a return to recession — is very low, and we think valuation of stocks compared to bonds is a very attractive play.”
Interest rates expected to be flat
Support for stocks will be dependent on interest rates remaining low, and both Croft and Raschkowan believe rates will remain near their current levels for most of 2010.
“The overlying theme on rates is all about the Fed,” Croft says. “This rally in the equity markets probably has further to go, as long as the Fed does what it’s doing, which is keep short-term interest rates low for a long period of time.”
Croft points out that the Fed’s historical position is to not raise rates until at roughly 12 months after the worst of unemployment — a lagging indicator — has passed.
“I think the Fed will leave interest rates lower for longer than the market is expecting,” she says, suggesting that the Fed won’t raise rates until late 2010 at the earliest. “Everybody is going to be fixated on the two year bond yield over the next year, as any kind of hint about where rates are headed. That’s probably one of the most important indicators of where the markets are heading right now.”
Croft says there are lingering inflation concerns beyond 2011, making long-term bonds a riskier proposition.
“We have all this money coming out of money market mutual funds and where are they are going? Bond mutual funds,” she says, pointing out that five in six dollars coming out of money markets are reinvested in bond funds. “I wonder if this is perhaps a contrarian indicator: is everybody heading into bonds at the very inflection point for yield?”
Similarly, Raschkowan says most of the growth has been played out on riskier assets, such as financial stocks and small-caps. He expects there to be strong movement to large-cap stocks, particularly sector-leading names.
“Secular growth will come back into favour. I think next year you will see more focus on stock selection. You’re going to see investors differentiating between who are the winners and who are the losers within sectors,” he says. “We’ve already started to see that in the financial sector, which is of course one of the sectors that rebounded the strongest off the bottom. In the initial rebound, any bank you invested did extremely well, now certain banks have started to differentiate themselves. Goldman Sachs and JP Morgan Chase both did extremely well.”
Beyond 2010, Raschkowan says investors should be wary of the return of the commodity cycle that dominated investment themes from 2003 to 2008. He expects emerging markets to clearly outpace North America and Europe in 2010, but when the developed world gets back on track, it could once again severely constrain global commodity supplies.
“Going out beyond three years, do we get back into another commodity price cycle? Our view is that is a very real possibility, that we could end up in a repeat of 2003 and 2007, with commodities spiking higher as you have steady increases of demand and much slower growth in supply. Canada would be well-positioned for this increase [as global leader in commodity production.]”
(11/19/09)