Sector review
The strongest performing sector was information technology (20.2%); consumer discretionary (17.3%) continued its strong performance in the first quarter.
The more defensive sectors of utilities (3.1%) and telecommunications (2.6%) noticeably lagged the index.
The European telecommunications sector actually fell over the quarter as the market was worried over the sustainability of high dividends given a demanding capital expenditure outlook.
Financials (17.7% globally) were strong on both sides of the Atlantic over the three months to end March. US banks advanced on strong Federal Reserve stress test results and European banks on the liquidity provisioning by the ECB.
Style view
After a strong 2011, high-quality and high-dividend yield strategies underperformed in the first quarter of 2012. The primary reason is that the influx of global liquidity supported the styles that had the worst performance over 2011.
High quality stocks underperformed low quality in Q1. In the US, the quartile of lowest quality stocks beat the highest quartile by over 13 percentage points.
Higher dividend yield stocks underperformed low dividend paying stocks. This was the case in both the US and Europe. Dividend growth as a style held up much better than strategies focusing primarily on dividend yield.
Globally, high risk and smaller capitalised stocks outperformed in the first quarter. In the US, however, there was no performance distinction across different size styles.
The outlook for equities
We do not forecast equity markets to have as strong a second quarter as was experienced in the first quarter of this year or the last quarter of 2011. The rally in equity markets over the past two quarters (the MSCI AC World Index has risen by nearly 20% in the 6 months to end-March 2012) has primarily been driven by a re-rating in the valuation of equities.
The 12-month forward valuation for global equities has risen from 10.8x at the end of 2011 to 12x by the end of Q1 2012. One reason for the increase in valuations is that analysts continued to downgrade their earnings outlook.
The trough in the earnings revisions ratio occurred in early Q1. More recently, however, the pace of downgrades relative to upgrades has begun to slow. Such a sign has historically been a support for equity markets.
Global equities should face a harder Q2 following strong returns recently and the modest re-rating of equity markets. Macro concerns will likely weigh on improving risk sentiment, but downside is limited by favourable medium term valuations and still light investor positioning.
First quarter earnings seasons may prove vital in giving investors greater clarity on 2012 earnings growth. In the US, since the start of the year, the consensus has reduced 2012 earnings for the U.S. by 2.7 percentage points to fewer than 9% earnings growth. Bottom-up analysts now expect only 3% year-on-year earnings growth in Q1 which appears undemanding.
My preferences
Our preference for the U.S remains, where we have greater confidence in companies achieving earnings expectations. Sales growth forecasts are more likely to be achieved, while margins should start to edge lower from peak levels, a collapse in margins to long-term averages is not expected.
In Europe, earnings growth for this year is expected at just over 5% (3% excluding financials), far lower compared to start-of-year expectations of over 9%. While macro headwinds reduce the likelihood of these expectations being met, the current valuation discount appears to have factored in no growth in earnings for this year.
Regarding emerging markets, we maintain our current positioning. A “soft landing” is still expected, and while concerns over China dominate near term developments, the structural growth exposure warrants an allocation.
Style-wise, our preference for quality companies with the ability to grow sustainable dividends remains in place. After a cyclical bounce over the past two quarters, these strategic themes should be re-confirmed, in our view.
Sector-wise, a balanced defensive/cyclical exposure is advised. Favoured sectors are technology and consumer discretionary, especially consumer stocks related to the growing purchasing power of the emerging market consumer.
