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MARKETINSIGHTSQuarterly Perspectives2 Developed market equities:It’s (not just) the economy, stupidTaking a stance on developed market equitiesWith 80% of MSCI AC World Index’s market capitalization in the U.S., Europe and Japan, itis important that investors take a position in these markets in order to achieve somediversification in their portfolios. In 2014, the U.S. came away as a clear winner even asinvestors worried about valuations throughout the year. Japanese equities were given anew lease on life by the surprise announcement of additional money printing by the Bankof Japan (BoJ) at the end of October. Europe was dragged down by weak economictrends, despite the European Central Bank’s (ECB) pledge to re-engage in quantitativeeasing. In this article, we look at these markets beyond the prevailing sentiment towardstheir domestic economies.U.S.: Sturdy economic growth with profitsOut of the three developed economies, the U.S. has the most robust macroeconomicbackdrop. After several years of de-leveraging by both the household and corporatesectors, the economy now has a stronger footing to expand. This boosts the FederalReserve’s (Fed) confidence in going ahead with monetary policy normalization, includingstarting to raise interest rates in 2015, albeit at a gradual pace.The corporate sector has also delivered steady earnings growth. S&P 500 earningsgrowth in Q3 2014 was around 10% year-on-year, with margin expansion contributingmore than revenue growth, as shown on page 34 of the Guide to the Markets – Asia.OVERVIEWU.S. equities led the developed market(DM) equities asset class in 2014. Thisreflected solid economic growth andconsistent corporate earnings growth.In 2015, the outlook for U.S. equitiesremains well supported, even thoughthis is a well-known story. Pessimism onEurope due to its economic downturnignores the fact that the region isgetting more help from low interestrates, a weakening euro and reducedfiscal austerity.Japanese yen depreciation is definitelyhelpful for Japanese equities, butcompetitive companies and a drive forbetter corporate governance should alsobenefit equity investors.United States: Sources of Earnings and Corporate ProfitsU.S. GDP and S&P 500 Year-over-Year EPS GrowthGrowth broken into revenue growth and margin expansion, quarterly50%25%0%Margin Share of EPS GrowthRevenue Share of EPS Growth34GTM - AsiaClickYear-over-year % changeGDP growth6%4%2%0%U.S. earnings growth is stilllargely derived from marginexpansion, rather than revenuegrowth.-25%-2%-4%Eq quities-50%-6%'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14S&P 500 Sector Forward EPS GrowthBuybacks and M&A ActivitiesEPS Growth (%) as of 12/2014USD BillionsUSD Billions, 4-quarter moving average1,60018030% 2014M&A Activities*Buybacks21% 20151,20012%1203%800-6%60-15%4000'00 '02 '04 '06 '08 '10 '12 '140Source: FactSet, Standard & Poor’s, BEA, J.P. Morgan Asset Management “Guide to the Markets – Asia 1Q 2015.”(Top) EPS based on operating earnings per share. 2Q14 figures are Standard & Poor’s estimates and based on company filings as of 30/6/14. 1Q09, 1010 and 2Q10 reflect -101%, 92% and 51%growth, respectively, in operating earnings and are cut off to maintain a more reasonable scale.* M&A activity is the quarterly value of deals completed.Data reflect most recently available as of 31/12/14.Source: Guide to the Markets - Asia, page 344 | Quarterly Perspectives: 1Q 2015
This consistent earnings momentum has helped to address concerns about highvaluation and continues to push S&P 500 to record highs. Given the U.S. growthperformance, especially in corporate capital expenditures, it is reasonable to expectearnings growth momentum to extend into 2015.What are the challenges to U.S. equities? Ongoing U.S. dollar (USD) strength could putsome pressure on companies’ overseas profits when translated back into USD. Thecurrent bout of weak oil prices could also hurt the material and energy sectors, althoughthis helps consumption by raising disposable income. The lack of revenue contribution tooverall earnings growth is also a disappointment, especially as company profit marginsare already at cyclical highs. Nonetheless, we believe the historical relationship betweeneconomic growth and revenue growth should start to play out more prominently in 2015.Europe: Downside protection to counter downbeat sentimentEuropean equities’ disappointing performance in 2014 was largely brought on byrenewed concerns over the region’s economy returning to contraction after a false dawnearlier in the year. This pessimism on poor economic performance continues to be one ofthe biggest challenges for European equities, but there are several factors that canprovide some support in the new year.The ECB’s pledge to push ahead with quantitative easing has yet to kick-start an upturnin the credit cycle. However, this has already started a push to weaken the euro, as wellas pushing interest rates lower, as illustrated on page 28 of the Guide to the Markets –Asia. A cheaper euro helps exporters to improve their competitiveness overseas or allowthem to enjoy bigger profits from overseas sales. Lower interest rates help to reducedebt servicing costs. Meanwhile, fiscal austerity measures, either via higher taxes orspending cuts, are being reduced and, hence will be less of a drag on economic growth.These favorable conditions may not bring a V-shape recovery to Europe, but they shouldprovide some support to corporate profitability in the medium term.conomyGlobal EcEurope: Monetary PolicyECB Balance Sheet and Euro REERReal broad effective exchange rate (REER)EUR Trillions115 ECB Balance Sheet 1.2(inverted scale)110 1.61052.0100Euro REER95 2.890'08 '09 '10 '11 '12 '13 '142.43.2ECB Bank Lending Survey ClickSupply and DemandNet % of banks reporting positive credit demand / supply28GTM - Asia80%StrongerHousehold Credit DemandDemand /Household Credit Standards60%TighteningCorporate Credit DemandCorporate Credit Standards40%Credit20%0%-20%WeakerDemand /-40%LooseningCredit-60%'04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14The ECB’s actions have yet toturn the region’s credit cyclebut low interest rates and aweakening euro are helpful.Sovereign Funding Costs10-year benchmark bond yields (%)15%12%9%6%3%0'12 '13 '1431/12/14 31/12/14Greece 9.4% UK 1.8%Portugal 2.7% Spain 1.6%U.S. 2.2% France 0.8%Italy 1.9% Germany 0.5%Eurozone Bank LendingYear-over-year % change15% Corporates12%9%6%3%0%-3%TotalHouseholds-6%'04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14Source: ECB, Bloomberg, FactSet, J.P. Morgan Asset Management “Guide to the Markets – Asia 1Q 2015.”(Bottom Left) Greece’s 10-year benchmark bond yield reached a peak of 32% in Jan 2012 and is cut off to maintain a more reasonable scale.Data reflect most recently available as of 31/12/14.Source: Guide to the Markets - Asia, page 28J.P. Morgan Asset Management | 5
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