At the start of the year we had projected that equities would beat fixed income: it is too early to be celebrating but we take comfort from market performance so far. We use this opportunity, though, to remind investors that it is unlikely we will experience a trouble-free year for equity markets, and expect the trend higher still to be rocky, in our view.
So far, risk markets have managed to shrug off an Italian election with no definitive result and a Cypriot bailout including a haircut to uninsured depositors, taking direction instead from almost universally positive economic news out of the U.S. Regionally, Japan has been the strongest performing region this year, and below we look into what may be required for this trend to persist. At the opposite end of the spectrum, core government bonds have so far not been able to repeat the returns of last year.
Global equities have risen 6.6% year-to-date in U.S. dollar terms. In the U.S., the S&P 500 and Dow Jones Industrial Average indices have reached record new highs. In Europe, the U.K. FTSE 100 Index and German DAX Index are at post-crisis highs, as is the Japanese Topix Index.
DM dominates EM
However, a rising tide has not carried all boats. Despite healthier growth rates in the developing world compared to advanced economies, developed equity markets have outperformed their emerging counterparts by close to 10 percentage points in the first quarter. One potential driver of this outperformance has been relative economic performance. Data releases from the U.S. have indicated both labour and housing markets are healing at an improving pace.
While the U.S. economy builds momentum, large emerging markets (EM) have stumbled by contrast. As we highlighted a fortnight ago (see EMEA CIO Weekly – ‘Cyprus bail-in – “We’re (not) all in this together”’), China has started the year in a lower gear. Retail sales data and industrial production have disappointed expectations. More importantly, economic surprise indicators show that while U.S. data have consistently surpassed market expectations, EM data surprises have been growing ever more disappointing since the first few weeks of the year. However, we expect that this trend should begin to reverse. Ultimately, better EM activity data may prop up local equities, potentially reversing some of their underperformance this quarter.
Another reason for equity market performance divergence may be currency effects. This is most notable in Japan, where the Japanese yen has weakened by 7.9% against the U.S. dollar year-to-date. Japanese equities have risen 11.7% in U.S. dollar terms (or 21.5% in local currency). Similar currency impacts can be seen for the U.K. equity market, given sterling’s 6.5% depreciation against the U.S. dollar. We think that a consideration for how currency movements impact asset class returns may grow in importance over the course of 2013.
Defensive over cyclical
Sector performance at the global equity level also highlights that investors may still be sceptical about the sustainability of a cyclical global economic uptick. Defensive, cash-generative sectors such as healthcare (+14.3%) and consumer staples (+11.6%) have outshone more growth-sensitive segments of the stock market, such as energy (+3.8%) and materials (-4.6%). However, as the independent Absolute Strategy Research point out, European cyclical sectors remain cheap for a reason, given that their year-on-year earnings growth is falling at around a 12% rate.
As earnings revisions ratios stabilise for global cyclicals, we believe that growth-sensitive stocks may begin to outperform more “bond-like” equity sectors. Yet presently, risk rather than return potential is driving investor positioning in our view. Investors have been more content to back lower volatility, income-generating sectors rather than the more attractively priced, growth-geared pieces of the global equity universe.
Nevertheless, our view that the rotation from bonds to equities will be a slow and steady process seems justified by other asset classes’ performance. Year to date total returns on the BofA Merrill Lynch U.S. Treasury and Agency Index are a modest -0.2%. We still believe that low real interest rates in the developed world mean that opportunities for positive total returns in core government bonds and investment grade credit are limited in 2013.
Total returns will likely be driven more by carry (the coupon) rather than further price appreciation from here. Yet developed market central bank rhetoric continues to signal an easy monetary stance for some time to come. This should limit the extent to which core government bond interest rates rise – yet we remain cautious on over-allocating to fixed income investments that offer little yield. In the case of investment grade, the negligible yield cushion is insufficient to compensate for the risk of higher longer-term interest rates than currently priced by the market, in our view.
Pullback on the horizon
We view the year-to-date rise in equities as encouraging but recognise the risks for second quarter pullbacks. Historically, 2010 and 2012 both saw strong first quarter equity performance, only to end the second quarter lower than the end of the first (by 12.3% and 6% respectively). We do acknowledge favourable developments in 2013 compared to previous post-crisis years – financial tail risks are notably reduced and policy accommodation is finally gaining traction in respect of credit expansion, particularly in the U.S.
However, we feel that some softening in U.S. activity surprise indicators in the second quarter (driven perhaps by fiscal drag beginning to bite in the real economy) is a risk not to be neglected. Circumspection, rather than unbridled optimism, should define second quarter asset allocation decisions, in our view.
As we mentioned above, over the last few months Japan has appeared to be one of the most favoured equity markets with the TOPIX Index gaining 43.2% (in local terms) since the market bottomed last November. The strongest performing sectors in this rally have been financials and consumer discretionary, rising by more than 60%. At the opposite, telecommunication services, consumer staples and energy only went up by around 33%.
Japan’s prospects
The recent rally has been principally driven by Prime Minister Abe’s economic policy announced last November which is based on three pillars: 1) an accommodative monetary policy stance, 2) flexible fiscal policy which includes a 2013 fiscal stimulus and 3) a push to boost private sector investment.
Within the three focuses, monetary policy has gained the most attention. To fight deflation and foster growth, a 2% inflation target was set-up along with asset purchases. The first visible impact of this strategy has been yen depreciation over the last few months. According to BofA Merrill Lynch Chief Japan economist Masayuki Kichikawa, a 10% yen depreciation adds 0.5-0.6% to economic growth after a one year time lag. As such, this should set a good environment for exporters.
On the political side, the government has started to draft bills to reform fiscal policy and foster growth with the objective to increase investment and boost consumption by raising wages. Low wage growth has been one of the main drivers of deflation in the last decade, so a pick-up in wage growth should help lift the price level, we feel.
BofA Merrill Lynch Japan Economics team expect real GDP growth of 1.5% in 2013 – although likely lower than 2012 growth rates, this is still higher than forecasts for both the eurozone and the U.K. But, with CPI inflation to remain close to 0%, we feel there is still more scope for the Bank of Japan (BoJ) to act further, especially as Governor Haruhiko Kuroda reiterated in March that the BoJ “will do whatever is necessary to overcome deflation”.
We would not be surprised to see the BoJ move forward the planned monthly ¥12 trillion Japanese government bond purchases from the start of 2014 to sometime this year. Additionally, like the Fed, the BoJ may look to increase the duration of its government bond purchases. So far the Japanese equity market has risen on expectations of resilient economic data and the introduction of a BoJ Governor with a strong easing bias. Over the next two quarters, we believe we shall likely need to see the delivery of these expectations to sustain the Japanese equity market’s recent strong performance.
