RBS upbeat on Equities but cautious on rising cost of capital

RBS upbeat on Equities but cautious on rising cost of capital

The Royal Bank of Scotland Plc (RBS) believes the cost of capital should increase going forward - a big change to the prevalent trend of falling bond yields over the past thirty years.

Economic Analysis

15 April 2011

The most important implications for equity investors are that real returns will be lower and volatility higher, both in Asia and globally.

The findings are highlighted in a newly released report: The Asian Angle: Regional Asset Allocation Guide - a quarterly view of the Asian financial market and asset allocation by country and sector.

Overall this change in environment will have less impact on Asia in general as the region is well positioned due to its current-account surpluses, general low public debt levels and aggregated savings surpluses. RBS is, and has been, upbeat on the prospects for the region: we expect absolute returns for equities of between 15 and 30% in 2011, albeit with continued high volatility. As such, the RBS Asian Angle team believes regional equities will continue their global outperformance witnessed over the past decade.

"We have seen US$8.3bn of outflows from Asia ex-Japan funds in Q1 2011, however, we expect positive flows to resume," said Emil Wolter, Head of Regional Strategy, Asian Equities.

"Ultimately in this changing environment the determining factor will be which countries are capital self-sufficient and which aren't". Mr. Wolter added that while Asia has cyclical challenges, they pale in comparison to the ongoing structural problems in advanced economies. Thus Asia’s structural advantages, illustrated by persistent yield and growth gaps, are likely to consistently lure back global investors and some speculative funds.

"We believe that equities remain the most attractive asset class as long as the world economy continues to grow," he said. "This will continue to be the case until interest rates exceed nominal growth in the main developed economies". RBS economic forecasts indicate equities will continue to outperform until long bond yields rise by another 200 basis points (bps). At 5-5.5% long-term bond yields (using ten-year US government bonds) global growth could start to falter and equities will consequently struggle.

The report also shows that a higher cost of capital will mean that the idea of ‘buy and hold’ equities becomes obsolete and investors will need to pay closer attention to economic cycles and valuations, both of which are likely to become more pronounced and have a greater effect on returns.

Mr. Wolter said financial stocks are most likely to benefit in this new environment. RBS has therefore upgraded the sector to ‘overweight’, taking a positive view for the first time in two years, following 800 bps of underperformance compared to regional shares.

"Banks do not have to deal with higher raw material costs and the Asian variety typically is lowly geared but facing good demand for credit, meaning the returns on equity will expand in the months and quarters ahead," Mr. Wolter said.

Among other high conviction ideas, RBS strategists believe Taiwan, and in particular, its banks - which previously suffered disproportionately as China exported deflation to the world - will be the largest beneficiaries as Chinese inflation becomes a problem. Chinese wages have been exceeding nominal GDP growth for some time, illustrating that supply of cheap labour on the mainland is not infinite.

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