Asset Allocation and Investment Strategy
March 14th, 2013
Commentators remain upbeat on equity outlook – March 2013
Andy Brunner, chief investment strategist at Morningstar OBSR, assesses the outlook for world markets and offers his thoughts on asset allocation strategy
When the Japanese Cabinet Office released its first estimate of fourth-quarter GDP in mid-February, it completed a dreadful period for the major developed economies, with every single one of the G5 and six of the G7 countries having recorded an economic contraction. The declines ranged from -0.1% quarter-on-quarter in the US (since revised up to 0.1%) to -3.7% in Italy and, in aggregate, the developed countries reported a near 1% fall in headline GDP. It was only a strong recovery by the emerging economies that prevented a worse global outcome and enabled world output to grow by 2.5% over the quarter, close to its slowest pace since the 2008/09 recession. It should be noted, however, that the contraction was not a function of a broad-based downturn afflicting all countries but, certainly in the US, UK and Japan, reflected a number of idiosyncratic features alongside the headwinds from ongoing euro area recession. Even so, this disappointing end to the year resulted in global growth falling to 3.0% for the full year from 3.8% in 2011. The current year has begun with renewed optimism with all but France of the five largest advanced economies expected to return to the growth path in the first quarter. Even so, the pace of advance is generally forecast to be pedestrian through much of the first half, although commentators remain fairly confident of an acceleration to an above-trend pace in the latter part of the year and into 2014. What is not necessarily obvious from the bare figures is the magnitude of the economic upturn anticipated during 2013. For the fourth quarter of this year, the US, China and Japanese economies are all forecast to be growing at an above-trend pace, the UK at 1.3% and even the EU, hopefully, will have returned to positive growth. The near-term outlook for the US economy is clouded by the difficulty in assessing the extent to which it will be affected by the substantial tax hikes that became effective in January and the sizeable government spending cuts scheduled to begin in early March. The strong fourth-quarter rebound in private consumption, hidden within the weak headline GDP figure, will undoubtedly slow over the first half but, with business activity rebounding, housing accelerating strongly and ongoing aggressive monetary support from the Fed, the goal of sustainable expansion could well be in sight before year-end. After contracting by 2.4% quarter-on-quarter in the final three months of last year, a far better current quarter is forecast for the euro area, led by a strong recovery in the German economy. Surveys of business confidence have improved markedly throughout the EU in recent months and, with financial conditions considerably easier as sovereign debt risks have receded, and timescales extended for austerity programmes, the euro area could well be growing again by second quarter. The medium-term outlook for the UK economy was viewed by Moody’s as sufficiently challenging to be a key reason for downgrading its AAA debt rating. Inflation continues to squeeze real incomes and, with the Bank of England admitting CPI growth will continue to exceed its target for some time to come, further monetary easing will be required – in the absence of any fiscal change of heart by Chancellor George Osborne – for the UK economy to avoid continuing stagnation. ‘Abenomics’ is having the desired effect in Japan with the yen’s 15% depreciation contributing to a surge in confidence the economy will grow strongly this year. While economic data is already improving and growth forecasts are being revised higher – virtually weekly – doubts remain whether the necessary reforms and deregulation will be initiated to boost the economy’s potential growth rate. Some of the more recent data suggests a modest slowdown in the Chinese economy, although data at this time of the year is always distorted by the lunar new year holidays, and new measures were recently introduced to control the property market as loan growth surged. The new State Council looks set to continue with similar growth and inflation targets and prioritise economic restructuring towards greater household consumption. Financial markets faced a more volatile month as the US sequester (automatic spending cuts), Italian elections and a growing debate within the Federal Open Market Committee (FOMC) on the future of QE all played out. In particular, currency markets swung wildly, particularly on the initial reaction to the surprising and disappointing Italian election result. With a coalition being seen as difficult to form, speculators and hedge funds tried to exit what has been one of the most popular and profitable recent trades, shorting the yen and buying peripheral EU debt. Unsurprisingly, the euro plunged 5% against the yen in just a few hours as Italian yields surged. Elsewhere, sterling continued its fundamentally justified decline as the Bank of England appears to be tolerating higher inflation, is considering additional QE and openly discussing the prospect of extending unconventional monetary policy measures that may include the introduction of negative interest rates. The clear winner in all this was the dollar, which in trade-weighted terms appreciated by 3.5%. Even following a more heated internal FOMC debate about the possibility of an early end to QE being firmly quashed by Fed chairman Ben Bernanke in testimony to congress, the dollar continued to gain momentum. Bernanke’s QE views, allied to some short-term safe-haven buying, also led to a sizeable rally in US treasuries which, as ever, buoyed other main government bond markets. In contrast, contagion in the EU periphery markets proved far less invasive and, after initial setbacks, Spain and Portugal both bucked the Italian trend. Interestingly, government issuance in Spain and Italy was well received as investors continue to chase higher yields, given OMT inspired confidence. Following a sell-off in early February, corporate bonds also rallied and yields headed back towards January’s lows. This was despite more cautious commentary from some highly respected investors warning that prices were becoming exuberant and irrational. Equity markets ended February a little higher, with the MSCI World Equity index up 1%. Returns for UK based investor were considerably higher, however, given the weakness of sterling against all-comers. Towards month-end many of the ingredients necessary for a healthy correction had appeared to be falling into place. Initial weakness was defused by Bernanke’s congressional testimony, however, as he implied financial markets were erroneously fretting over an early end to QE and minimised concerns about asset bubbles to the extent he noted no overvaluation in equity markets. US, and indeed global, investors needed no further invitation to return to the buying tack once the Fed chairman had, to all intents and purposes, sounded the all-clear. One new trend in equity markets, perhaps driven by receding global risks, is a decline in index and stock correlations. Even as most markets rallied, a number of the main emerging markets fell significantly during February, mostly for idiosyncratic reasons, while Japan continued to rally strongly driven by the economic changes taking place. One country where fortunately economic developments do not matter overly is the UK where the truism “the UK economy is not the UK stockmarket” should be a mantra for investors. International markets account for more than 75% of UK index sales and, importantly, a large proportion of that is to strongly growing emerging markets. It is quite probable, therefore, that FTSE index targets will be on the rise should sterling remain weak. Other recent features in stockmarkets include a substantial rise in M&A activity, increasing stock buybacks and signs of investors closing underweight equity positioning. This is indicative of building momentum and supports the view of many commentators, who remain resolutely bullish through the balance of the year. Even though equities rallied at the end of February, commodity markets fell away quite sharply. This perhaps reflects the improvement in US economic sentiment being supportive of equities while data from China, which is far more important for many commodities, disappointed in the latter part of last month. Gold is also losing its lustre and a number of well-known hedge fund managers have reported reducing gold exposure. UK commercial property values fell once again but at a slower pace and indeed the total returns in January were the highest since last April. A number of leading agents noted ‘green shoots’ appearing in better-quality secondary property and there is no doubt investor interest in the sector is waxing. With regard to asset allocation, the vast bulk of commentators continue to favour equities as the asset class of choice for 2013. With 10-year bond yields hovering below 2% in both the US and UK, bonds remain poor value on a medium-term view with a clear risk of negative returns over the next few years. Short-term squalls are inevitable for equities, especially given the pace and scale of the advance but, until the credit cycle turns, the broad trend should continue upward. Taking all this into consideration, our current asset allocation views are:
The global economy is set to remain in a period of sub-par growth through the first half of 2013 but with the prospect of a return to above-trend growth towards year-end. Equity risks remain and near-term concerns suggest a period of consolidation and increased volatility after such a strong start to the year. Even so, economic and financial trends have resulted in coordinated policy responses from governments and central banks that will continue until economic recovery becomes entrenched. These actions have also lowered perceived risk and should be sufficient to encourage investors to build equity weights in portfolios. Therefore, we retain a long-term overweight position. Tactically we have few biases sectorally and the pro-cyclical tilt has been removed. The recommended strategy for long-term investment in a relatively low growth/low inflation world, however, is to buy exposure to growth markets irrespective of sector and size, focusing on good quality companies with healthy balance sheets and strong cashflow. Yield will also be sought in a low interest rate world and higher-yielding stocks with rising dividends also remain preferred.
Relatively weak economic data and financial repression have kept government bond yields at very low levels by historical standards. Most of the main central banks remain committed to bond-buying programmes for some time to come and that of the UK could soon be reactivated. Government yields are generally still well below headline and expected future inflation rates, however, and from a sub-2.0% starting base in the US and UK medium-term returns could well be negative should, as the consensus expects, economies accelerate, labour markets improve and QE come to a natural end. Investment grade corporates offer better value with spreads likely to continue to narrow. Even so, yields are at all-time lows and, with the probability of rising government yields, some capital loss may well offset spread compression but there is still a pick-up in income. Investors should still include riskier UK and US investment grade credits and emerging market debt in portfolios although risk/return is nowhere near what it was. High yield is becoming more worrisome.
The decline in UK commercial property values continues, albeit partly offset by gains, in Central London offices. While the outlook for the year remains unclear, given financing difficulties and secondary property yields continuing to widen, growing investor interest should limit the downside and a number of commentators are now forecasting an end to capital value losses this year. With a near-7% yield and record yields gaps relative to bonds and cash, property could prove increasingly attractive to income starved institutions.*
A global economic background of continuing low growth and, in particular, the rebalancing of the Chinese economy towards consumption with a consequent significantly lower-trend growth rate, presents a more difficult medium-term backdrop for many commodity producers. This represents a departure from the structural bull market witnessed during the last decade and will lower potential returns until capacity tightens again. This is not a new story and commodity indices have been underperforming equities for nearly two years. A large part of the prior upturn in commodities was driven by speculative activity but interest in this newish ‘asset class’ is losing steam. This is becoming increasingly evident in gold and while there may be short-term upside for copper and crude oil, the consensus expects lower long-term price structures.
The recent sizeable increase in foreign exchange volatility and main cross-rate swings underlines once again just how difficult currencies are to predict. Looking forward, the yen’s depreciation has taken the real effective exchange rate to within a few percent of its all-time low and ‘currency war’ issues should prevent much more of a slide. The euro has unwound its earlier overbought condition while sterling’s recent decline has left it heavily oversold. Some stability should return to the major crosses at current levels and, for what it is worth, forecasts suggest only modest changes through to year-end. With regard to the longer term, Asian and emerging market currencies remain the preferred choice.