SPANISH STOCKS COST ONLY TEN TIMES FORWARD EARNINGS

Amid all the despondency about the economic prospects of “the West,” it’s refreshing to find an optimist with a coherent argument. Chris Watling of Longview Economics believes that the West is on the threshold of an economic boom.“It is anathema to talk about it given recent experience,” he admits. But he points out that inflation, although sticky, is dissipating. Interest-rate cuts have already started and will spread to the US and UK. The US economy has performed well, helped by productivity growth, and now faces a soft landing rather than a recession, which will be followed by renewed growth.

 

The eurozone has been stagnating as it deleverages, but growth is now set to quicken, led by southern Europe, while the UK will benefit from real growth in wages, rising corporate profits and a pick-up in the housing market. Since the “Brown boom” in 2008, household debt has fallen from 95% of GDP to 80%. It will now expand, as it did in the Barber boom of the early 1970s and the Lawson boom of the 1980s.

 

Consumer debt relative to GDP has also fallen sharply in the US and Europe, after a short surge in 2020 as Covid cut economic activity. This puts into context the rise in the ratio of government debt to GDP. As governments have borrowed, households have retrenched, so overall debt relative to economic output has been flat or declining in many countries.

 

The trigger for the retrenchment of households was the 2008 financial crisis, which forced the banking sector to de-risk. “A well-capitalised banking sector now has capacity to expand.” The primary avenue for this is mortgages; in the UK, net mortgage lending is depressed, as are US existing and pending home sales and Spanish building permits. Mortgage-debt service costs as a percent of GDP have fallen sharply.

 

GOVERNMENTS BASH THEIR BALANCE SHEETS

The media narrative in Britain is about the shortage of housing and its unaffordability, but nine million households in England now own their properties outright and only 6.5 million have mortgages. Net housing wealth has risen from £3trn in 2008 to £7.1trn, creating huge potential for equity withdrawal, which surged in previous boom periods. Twelve million renting households face rising costs, providing a strong incentive to buy, with affordability improving as interest rates fall. In the US, net housing wealth has risen from $8trn in 2012 to $32trn.

 

Household savings ratios have risen in the UK to levels only seen in 1990 and the pandemic; in Europe, they also stand at historically high levels, although less so in the US. There, the corporate sector has “terrific” cash flow, even excluding the technology sector. “It’s been governments that have been bashing their balance sheets in the last five to ten years,” says Watling, “not the private or household sectors.”

 

We hear much about Germany struggling, but little about southern European countries that “have been getting their houses in order since the euro financial crisis of 2011”. Germany “will be the sick man of Europe”, weighing down on eurozone interest rates, while southern Europe, helped by tourism and golden visas, continues to grow. One result of this acceleration in growth will be higher tax receipts and, potentially, consequent falls in budget deficits and public debt-to-GDP ratios. In the UK, this could finance large tax cuts or, more likely, the throwing of yet more money into the public-sector black hole. But there is a caveat. The determination of governments, actual and potential, to close down North Sea hydrocarbon production and the industries and services that depend on it, to deter tourism and to drive out non-domiciles, the wealthy and the well-paid (a sort of reverse golden visa) could lead to growth remaining far below potential.

 

What about equities? “With a change in the global economic outlook, you tend to get a change in market leadership,” says Watling. US valuations “are rich, and not just for the Magnificent Seven that now account for nearly 20% of the global market capitalisation”. The top 10% of US stocks make up 75% of the total valuation of the S&P 500 index, a similar figure to 1929. Every sector except energy and real estate is at, or near, the top of its historic valuation range.

 

However, Tan Kai Xian of Gavekal Research reminds us that “in the absence of a US recession – and there is no reason to believe a recession is imminent – US equities are likely to continue to trend higher on a 12-month time horizon. But a pullback in the second half of the year, on the back of higher economic and market volatility, is a substantial risk”. 

 

The rise in corporate profits that Ed Yardeni of Yardeni Research expects may value the S&P 500 at an expensive 21.5 times 2024 earnings. But that falls to 19.9 for 2025 and 17.9 for 2026. US stocks may require patience and merit some profit-taking, but not panic. Watling prefers the potential in Europe and the UK. He points out that the Italian market had, as of 31 May, outperformed the US this year, but still trades on less than ten times prospective earnings, while the Spanish market trades on only a little more. “These markets are now getting earnings growth, having retrenched for ten to 12 years.” In the UK, he favours Lloyds Banking Group, “one of the most hated stocks in the world… It will give back lots of capital and grow earnings, but is valued at just five to six times expected earnings”. Unless the next government imposes major new taxes and financial burdens on it, that is.