Over the past ten years, we have seen two distinct regimes, 2003-07 and 2008-12. And the third regime begun in 2013, say Citi Research analysts Beata M Manthey and Jonathan Stubbs. Normalization and the return of animal spirits will be the key characteristics of the third regime. The 2003-07 period was marked by leverage, low macroeconomic risk and intense corporate action. The second regime witnessed little corporate action, high macroeconomic risk and de-leveraging.
Now, the Citi Research analysts see the signs of re-leveraging and reduction of macro risks. Corporate activity is picking up, but economic growth is still modest. Analysts expect this period of low rates, low inflation and modest growth to continue for the next few years. The United States and the UK may increase interest rates before the Eurozone and Japan. But raising interest rates would take a long time given the heavy debt burden on several economies.
In such an economic scenario, the analysts say equity investors should focus on 7Rs. They are:
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Restructuring has been necessary for struggling economies as well as banks to improve their competitiveness and current account balances. European countries such as Ireland and Spain have done their job well on restructuring. Beata M Manthey and Jonathan Stubbs said restructuring is the key reason they are bullish on the European insurance and banking sector. Amid sluggish economic growth, financial and operational restructuring has driven the profitability and share prices of several companies over the past two years.
International economic outlook is improving. The analysts say Europe is no longer trapped in recession, though the recovery isn’t particularly strong. How European equities perform in 2014-15 will depend on the prospects of economic growth and earnings growth in the region. Citi Research expects 10% earnings growth in 2014.
Trends over the past 12-18 months reflect that macroeconomic risks have abated. That has increased the risk appetite of consumers, investors, capital allocators and corporations. Capital allocators have started accumulating equities after several years of the relative absence. Corporations have started showing less defensive behavior, especially in the U.S. The past few quarters have seen a pick-up in M&A activity.
Citi Research expects the re-risking trend to continue unless economies witness some significant change such as a fresh recession and a sudden spike in interest rates.
We saw heavy leveraging ahead of the 2008 financial crisis. Since then, many economies and corporations have made attempts at de-leveraging. Governments worked hard to slow the increase in their sovereign debt/GDP, and some countries are still de-leveraging. But the corporate sector was quick to respond. They repaired their balance sheets soon after the financial crisis. As a result, many companies in the U.S. and Europe have started re-leveraging. Their strong balance sheets and cash reserves indicate that the corporate sector has significant potential of re-leveraging.
The analysts expect re-rating of equities to be driven by low macro risk, rising demand for equities, nearing earnings trough and low equity risk premium. On a CAPE basis, European equities appear cheaper but they currently trade at 40-50 year average P/E levels. It indicates that European equities are neither cheap nor expensive.
Capital returns will be an important theme for equity as well as multi-asset investors. In the U.S. market, buyback, income and share shrinker strategies have performed very well. While in Europe and the rest of the world, income strategies have provided solid returns. Companies with surplus FCF and good dividend history have performed well in the post-crisis period.
Finally, regulations will play a key role in how various sectors such as healthcare, insurance, banking, telecom, etc. perform in coming years.