Global equity markets, led by the U.S., have continued to recover from their lows hit during the 2007-08 financial crisis. To assess the potential for further gains, I find it useful to take a longer-term perspective.
On a 10-year basis, whether looking at the U.S. or the global market as a whole, annualized total returns are still below historical averages. On a trending basis, equity valuations still don't look very expensive to us, either on a price-to-earnings basis or on a price-to-book basis. In fact, they're still not back to their historical averages.
We think the global recovery that the U.S. economy appears to be leading may be sustainable for several reasons. Within the U.S., a critical aspect of any recovery in our view is consumption, which accounts for 70% of gross domestic product. In this regard, the U.S. consumer has deleveraged, and savings rates have come up substantially since the financial crisis.
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The rebound in U.S. equity markets since then has enabled household wealth to recover in tandem with the housing market. And yet, looking at the housing market today, it still isn't driving the economy to the extent it had been before the crisis. We think there's more housing market recovery potential. Meanwhile, unemployment levels have fallen substantially, energy prices are low and the U.S. continues to enjoy low inflation. So we think this bodes well for a further recovery.
Some would argue that the strength of the U.S. economy has made the U.S. market more expensive DDDDthan the rest of the world. By most market metrics, advances in U.S. equities do seem to reflect the economic recovery there, which is further advanced than in most other developed nations.
EUROPE TURNING THE CORNER
Europe's recovery has lagged the U.S., in large part due to the fiscal austerity measures that were introduced in some of the hardest-hit countries in the European Union as a condition for receiving bailouts. However, we think Europe may be turning the corner. In fact, we have been interested in European equities for the past couple of years because we have seen them generally trading at such a substantial discount to the U.S. and to their own history.
We are particularly excited about the investment prospects in Europe, given that European equities still have not experienced a corporate earnings recovery as we have seen in the U.S. In contrast to the U.S., operating margins (the proportion of a company's revenue remaining after paying for variable costs of production) in Europe have not yet recovered strongly. Many have tried to blame this on structural reasons such as inflexible labor markets, higher taxes or some other factor specific to Europe. However, considering historical data, this has not been an impediment to European companies in the past. In our view, as Europe's economy starts to recover, we will likely see European earnings recover.
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The significant amount of cash on corporate balance sheets is one of the factors that gives us confidence that there may be more room for global equity markets to perform well. It provides companies choices, including whether to invest to expand their businesses, to pay higher dividends or to buy back shares. All of these options potentially increase earnings and returns. Companies could also invest to improve technology, which drives productivity and earnings growth.
As long-term, bottom-up investors, we go to places where the catalysts for improvement may not yet be clearly visible. We look at a time horizon of at least five years and invest where others often may not because we are willing to be patient. As we look around the world at where we are finding values now, financial stocks stand out to us. In the U.S. and Europe, a lot has happened in the banking sector since the financial crisis. In the U.S., banks have deleveraged and restructured, bad loans have been written off or have recovered. Therefore, banks are starting to provision less and profits are starting to improve. U.S. banks are also starting to see some loan growth. European banks are slightly behind in this process but are appearing to show similar improvements. We believe very little of this seems to be reflected in current valuations because the sector remains so out of favor.
OIL SERVICES LOOKING GOOD
Oil services are another area we like for similar reasons. Energy company share prices have been under some pressure from expectations of increased oil supply in the future as well as less productive capital investment for exploration and development by large integrated oil companies. Conversely, oil service companies have continued to benefit from many of the recently discovered oil and gas reserves, which require increasing levels of technology and services to extract. That said, when there are concerns about oil prices in the global markets, oil service company shares tend to suffer. In the past couple of years, we have taken advantage of these market conditions. When many are focused on near-term issues, we have looked to buy into some of what we believe are premier oil service companies like Halliburton and Baker Hughes and more recently some names in Europe, which we feel should be the beneficiaries of structural changes in the industry for years to come.
Based on all the exciting investment opportunities we are seeing in global equities, it should not be surprising that the current Templeton Global Balanced Fund allocation TODAY is 70% equity and 30% fixed income.
Lisa Myers is executive vice president, Templeton Global Equity Group.
