Economy goes into rehab… but markets say “no, no, no”11 December 2013
Jason Hollands discusses Bestinvest’s outlook for 2014 and predicts “Muddy Waters”
- Invest in the markets with the greatest potential for further stimulus: Europe and Japan
- UK equities ‘fair value’ but the recovery is more fragile than it seems
- US equity valuations look stretched
- Emerging markets are cheap but face serious headwinds
As investors and advisers ponder the prospects for the coming year, it is worth first of all reflecting on the progression of markets over the last year.
At the start of 2013 Bestinvest had a firmly bullish view on equities while warning of the growing risks in fixed income should markets begin to factor in a change in interest rate expectations.
Central bank asset purchase programmes - so called "Quantitative Easing" (QE) - had driven bond prices up and yields down, to the point where investors needed to search further up the risk curve to make a real return after the impact of inflation. Conversely, we felt that most major equity markets were cheap compared to their longer term trend and were underpinned by attractive yields.
Behind this stood the tailwinds of the second round of QE by Bank of England in 2012, the continued $85 billion a month asset purchase programme by the US Federal Reserve and the launch of an aggressive expansion of the country’s monetary base by the Bank of Japan.
The unusual alignment of fundamental value and abnormal stimulus measures created a sweet spot for developed market equities during 2013 and investors have been well rewarded as the following table demonstrates:
Source Lipper / Bestinvest. Total return from 31/12/12 to 6/12/13. This information is representative only of the time period discussed in this press release and should not be considered an indicator of longer-term trends in performance
Yet with some indices now trading at or near all-time highs, the outlook for 2014 is considerably more nuanced in our view that it was just a year ago.
While the continuation of extraordinary stimulus programmes could propel risk assets much higher, and anaemic growth suggests policy will need to remain accommodative, there are less obvious bargains to be found than twelve months ago.
Policy trumps fundamentals, for now
We therefore believe that policy is going to continue to be a primary driver of markets. This is a pattern that has been increasingly evident since Ben Bernanke first raised the prospect of the US Federal Reserve eventually reducing the extent of its monthly asset purchasing programme (“tapering”) from the current level of $85 billion in May.
Markets have been reacting to data releases in a manner that many would regard as counter intuitive, even perverse. Positive economic news is received badly (as it is suggests stimulus might be reduced) and weak data is well received (as it offers the prospect of continued doses of mind blowing stimulus).
In taking extraordinary measures to keep economies afloat, central banks have turned their patients into drug addicts, and over time such stimulus has started to suffer from the law of diminishing returns. Great care will need to be taken to unwind this addiction through slowly reducing the dosage, as the consequences of embarking on a full “cold turkey” scenario could be chaotic. Markets assume progressive tapering will take place during 2014 and all eyes are on the next Fed Open Market Committee meeting on 18 December.
In an environment where real growth remains fragile and valuations are less compelling, we think the right strategy is to favour markets where monetary policy is likely to become more proactive over those where such stimulus could potentially be wound-down or which have been co-beneficiaries of such QE programmes. This leads us to favour Europe and Japan over markets such as the US, UK and Emerging Markets for 2014.
Europe: on an irresistible path to stimulus
To be clear: the Eurozone is not in good health. In fact it is staring down the barrel at a scenario of weak growth, credit contraction and deflation. We believe that the recent move to cut interest rates will be just one action in a process of extraordinary measures to jump start a recovery. As we know from the experience elsewhere, this could lead to asset price inflation. We believe mid and small cap biased funds would be key beneficiaries, with our favoured fund in this space being Baring Europe Select.
Japan: further Yen weakening ahead?
There has been increasing scepticism towards the reform programme of Prime Minister Shinzo Abe in recent months and Japanese growth rates for Q3 have been revised down significantly. Yet if anything, the fear of policy failure will force the Bank of Japan to accelerate its shock and awe money printing programme. Combine this with the potential commencement of a process of tightening in the US and strengthening of the Dollar this should create a scenario that is both
favourable to Japanese exporters and makes Japanese assets look cheap for international investors, spurring stock prices higher. Our favoured Japanese large-cap fund is GLG Japan CoreAlpha.
UK: fair value but we question the sustainability of the recovery
Improving data and upward revisions in growth forecasts provided the Chancellor with an opportunity to gloat when he delivered his recent Autumn Statement. However, we are sceptical about the longevity of a recovery which is still sailing on the tailwind’s of 2012’s QE programme, is heavily based on measures that have boosted the residential property market and which has had the additional fillip of £12 billion of PPI compensation claims filtering into the economy.
While the Government preaches the virtues of austerity in the public finances, household debt has been rocketing and the savings ratio has slumped against a backdrop of ultra-low interest rates. Even a modest cost in servicing debts could have an ugly impact. For now, however, bullishness prevails and the decision to pull support for mortgages out of the Funding for Lending scheme should help improve lending into the broader economy. To play the UK recovery, we consider that investors should focus on the more domestically orientated mid-cap universe. We favour the AXA Framlington UK Mid Cap fund.
US: better value elsewhere
While superficially Price/Earnings ratios may not look overdone, corporate profit margin expansion has been driven to a considerable degree in recent years by cost cutting and the ability of companies to refinance at ultra-low interest rates. A turning point in Fed policy would likely see borrowing costs rise, in which case earnings growth may have peaked. On a cyclically-adjusted basis, the P/E of the S&P 500 is currently standing at around 25.2x earnings, compared to a long-term average of 16.5x and we therefore feel the US market is expensive. Notably, leading value investor Warren Buffet recently confessed in an interview “We’re having a hard time finding things to buy”. While acknowledging the current bull-run may roll on for now on the basis of momentum, we think better value is available elsewhere.
Asia and Emerging Markets: Optically cheap but facing serious challenges
We are long-term bulls of emerging markets but they have now underperformed developed market equities for three successive years. And while some may conclude that current valuations present a bargain basement opportunity, a US exit from QE could initiate a process of re-pricing of risk around the globe which would be painful for these markets. The ultra-low yields of recent years stemming from QE have provided cover for significant emerging market debt issuance with total emerging market debt estimated to have doubled since the Fed embarked on QE. A rise in developed market bond yields is going to have a knock-on effect into these markets.
We remain particularly cautious towards China. In the words of former Chinese Premier Wen Jiabao, the Chinese economy is “unstable, unbalanced, uncoordinated and unsustainable”. It has become over-reliant on inefficient, debt funded internal investment. Declining capacity utilisation in the manufacturing sector combined with rising non-performing loans underwritten by local government authorities suggests the Chinese banking system is under increasing capital pressure. Already, moves to withdraw liquidity are driving up funding rates with corporate bond yields at post crisis highs. Yet with the new leadership signalling that country needs to maintain GDP growth of at least 7% over the next decade to sustain job creation, there is a real risk that the pursuit of growth will allow the imbalances to become even more pronounced and the temptation must be building to devalue the Yuan to improve export competitiveness, a move that could reignite the prospect of currency wars.
Commodities: is the super cycle over?
China has been an important driver of commodity prices over the last two decades and given our scepticism towards the sustainability of China’s current model and the fragile nature of growth globally, we remain cautious in our stance towards industrial metals and other raw materials.
Gold, which is widely seen as a hedge against the debasement of paper currencies, met its Waterloo in 2013, despite unprecedented levels of money printing. Should the Dollar strengthen and bond yields rise during 2014, it is difficult to see how this would benefit the relative attractions of the zero-yielding yellow metal.
Bonds: back on the radar during 2014
And finally, back where we started twelve months ago: fixed income.
Bond markets have already started to adjust to expectations of a reigning in of QE and future changes in the yield curve, with spreads widening materially. The shakeout is expected to continue once the Fed starts to exit its asset-purchase programme, and therefore risks remain for now, but at some point we expect see quality bonds back on the radar for investors. For now, we support sticking with funds with flexible mandates, such as TwentyFour Dynamic Bond.
- ENDS -
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