Market movements, however, did not defy fundamental factors; there was a notable improvement in the momentum of changes to forecasts of corporate earnings while valuations are reasonable and fund inflows have continued. Inflation pressures remain low, the outlook for economic growth is steady and there is sufficient liquidity to support both bond and equity markets.
The widely-expected seasonal market setback in May failed to happen and there is little reason to expect a noticeable setback until markets have moved significantly higher. The sectors, such as technology, biotechnology and smaller companies, which retreated in April have at least stabilised while the rest of the market climbs steadily, yet the pace of the climb is not swift enough to tempt profit-taking or a capitulation into equities by the overly cautious.
The macro-economic worries, notably China, have not gone away while concerns about the Eurozone are rising again but equities, rightly, are focused on the reasonable valuations, favourable outlook for earnings growth and net cash-flows into the market. A month ago, we brought forward our expectation of a sustained rally from later in the year to the imminent and this has worked well. We expect markets to move higher in June and thereafter.
Bond yields have also confounded expectations by continuing to fall. The market is awash with ex-post rationalisations of this, combined with assurances that this is just an anomalous short-term deviation from an inevitable upward path.
Our view is that returns from government bonds will be positive to the year end, though probably not thereafter. The continued tapering of quantitative easing in the US and the need to follow it with interest rate rises there and in the UK is well known and discounted in current bond valuations. Spreads on investment grade bonds and, especially, on high yield have fallen to low levels, making negative returns over the next year more likely. EM debt is likely to continue the trend of recent months by posting firmly positive returns.
Overall, the outlook is for modestly positive bond returns, but they should be a useful counter-balance to equities in the event that the equity outlook deteriorates unexpectedly.
In our view, the one thing to which markets are paying least attention is the long-term. Short-term worries remain front of mind, with markets scrabbling for macro reasons for what might hold them back. We think they are missing the reality that equities are currently moderately priced for the long-term.
Whilst this doesn’t mean to say they are cheaply priced, we are living in a world in which interest rates are zero, in which bond yields are lower than they have been for centuries, and in which property prices, particularly in London and other major cities, are sky-high. We would ask the question – why should we expect equities to remain moderately valued? If earnings forecasts are underpinned, then we would expect a re-rating in equities.
This view applies not only to the year ahead, but to our view of the next three years. These may not be consistent, featuring difficult spots, but overall we believe there is a great long term outlook for markets and, with good returns for investors.
Whilst equities should out-perform bonds for the rest of the year, and though we are increasingly cautious about bond markets, we expect returns to remain positive. Bond markets may be showing investor complacency about the outlook for interest rates and inflation but they may also be showing the complacency of an economic establishment guided too much by the past.
Whilst the consensus view holds that little will happen until the second half – with investors selling in May and going away for the summer, we disagree. We think that markets are beginning to rally now. Whilst this doesn’t mean preclude exposure to bonds, but it does appear to mean to indicate a possible move out of cash. At a time when few are prepared to take good news at face value but many rush to see bad news around every corner, this is proving to be as benign a background for multi-asset investment as we could hope for.
