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Cheap side

As the world looks on at the unrest in North Africa and the Middle East, curious to know whether democracy will flourish or fundamentalist regimes take hold, the equity markets have barely moved. In the month of January, the MSCI World Total Return index registered a 0.02 per cent dip in sterling terms.

Global politics has been a huge distraction as traders and ordinary investors wonder what the future has in store. In doing so, they have overlooked some positive economic data. The decline in UK GDP for the final quarter of 2010 was clearly an upset but the CIPS/Markit manufacturing survey for January reached a record high and the services survey indicated brisk expansion, suggesting a rebound in economic growth in the first quarter of 2011.

In the US, economic growth accelerated in the final quarter of 2010 to an annualised rate of 3.2 per cent and consumer spending rose by a respectable 3.5 per cent in 2010. In emerging markets, the fear is not so much will their economies grow but whether they can continue to grow so rapidly without inflationary problems. Taken together, it seems reasonable to believe the world economy can grow by 4.4 per cent in 2011 as fore- cast by the International Monetary Fund.

Such an economic background should provide support to share prices and enable companies to build on the strong earnings increases they have been able to report. So far in 2011, the signs are encouraging, with the majority of companies that have reported in January beating earnings forecasts.

Nevertheless, the market has reacted nonchalantly to the results. It would appear that analysts who have been playing catch-up for so many quarters had raised the bar this time round so that even stellar results have struggled to impress.

Ultimately, this is no bad thing. Benjamin Graham, the celebrated investor and inspiration for Warren Buffett, once said: “In the short run the market is a voting machine but in the long run it is a weighing machine.” In other words, stocks are affected by investor sentiment in the short term but, ultimately, stock prices will reflect what they are worth.

With that in mind, it is worth noting that companies in general start 2011 in far better shape than they began 2010. Profits are up and balance sheets are even stronger. Companies with strong business models are finding it cheap to borrow in the credit markets. With yields on corporate bonds often below earnings yields at companies, the temptation to acquire rivals is strong and the math- ematics in terms of earnings accretion makes sense.

As yet, however, there has not been a huge leap in takeover activity, while fund-flow statistics show ordinary investors are only reticently shifting their focus away from bonds towards equities. This trend may gather momentum if inflation concerns build, given that government bonds appear to offer little compensation for inflation at current levels.

This healthy degree of scepticism to chase equity markets too high means valuations look attractive, with world equities in aggregate trading well below their long-term average. That does not mean market corrections can be ruled out. In common with most years, something is likely to come along that will temporarily spook investors.

In 2011, this might take the form of a resurgence of sovereign debt concerns, renewed inflation worries or disappointing economic data. It may even be something altogether unexpected. Who, after all, would have predicted the political upheavals in North Africa? A near-term pullback after the strong end to 2010 is a possibility but equities are inexpensive in valuation terms and, with companies in rude health, share prices should be capable of making gains over the course of 2011.

Bill McQuaker is head of multi-manager at Henderson Global Investors


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