Not surprisingly, given the outsized returns experienced in 2013, the first quarter of 2014 was a lot more volatile than at any time over the past year or two. In the end, however, equity markets were essentially directionless over the full quarter.
The causes of the elevated volatility can be attributed to a number of confidence-sapping events, namely: unsettling geopolitical developments in Ukraine/Crimea; ongoing political friction in the US; the commencement of the US Federal Reserve Bank’s (Fed) so-called ‘tapering programme’; slowing growth in China coupled with worries regarding the solvency of certain financial companies; and the overall backdrop of disappointing economic news coming from the US economy. The reasons for the slowdown in US economic growth, below the steadily recovering trend of 2012/13, are largely attributable to the extreme winter weather conditions. While a very plausible explanation, investors nonetheless chose to become fearful that the forces of deflation were very much still at play in the US economy. This, at a time when the Fed is steadily, and seemingly unwaveringly, withdrawing the monetary stimulus upon which investors have become so reliant. What transpired in the equity markets was a mini sell-off during January, with markets down by around 4% that month; and a return of confidence in February, following assurances from the Fed that liquidity withdrawal will only continue contingent on positive supporting data. The net result was that equities ended the quarter slightly up by 1.4%.
Despite this relatively benign outcome, there were, however, a couple of noteworthy underlying trends that emerged during the quarter. Those that merit comment include a 7% positive rally in the gold price; an 11% and 14% drop in the prices of copper and iron ore respectively; and a continued underperformance of emerging markets at the expense of developed markets. While the price of gold (one assumes) rose as a result of the increased level of anxiety prevalent in investment markets during the quarter, the latter two factors would seem to suggest ongoing concerns regarding the sustainability of economic growth in the emerging markets block. These concerns largely relate to lower growth and overextended credit markets (China); overextended current account deficits (Brazil); and overextended military ambitions (Russia). China still remains the largest wild card, as government policymakers attempt to rein in the credit excesses of recent years. Investor attention in China is now focused on mounting troubles in the nation’s shadow banking system, with the potential for a wave of defaults by ‘wealth management products‘ looming in coming months. Although one faltering trust loan of 3 billion RMB – ‘Credit Equals Gold No. 1’ – sold by the Industrial and Commercial Bank of China was bailed out at the end of January, there are reportedly more potential problems looming in the April – June period.
As Coronation’s clients know well, we are an investment company that, for the most part, believes in the attraction of a portfolio of well-selected equities. This is both in absolute terms and in relation to other asset classes. When we refer to absolute terms, we are talking about the creation of sustainable wealth by growing investment values in excess of inflation over the medium to longer term. We are therefore mindful of the potential accusation that we are blindly positive on equities at all times – come what may. With this in mind, two points need to be made. The first, and of lesser importance, is to remind readers that at the time of our December 2013 report, we stated that we expected 2014 to be a more turbulent and not necessarily upwardly trending year (in contrast to the outcomes of 2013). The second point refers to the current level of equity markets, which are clearly higher than they were in five years, and gaining perspective by looking at the long-term returns from the US and UK equity markets. Dating back to 1964, history shows that the sustainable level of real annualised returns average out at 5.9%. Not surprisingly, following the financial crisis in 2007/08, the rolling 10-year real annual return from equities fell to an extremely low number of -7% at the low point in early 2009. At that time, history suggested this to be a very compelling buying opportunity. Equity markets have since rallied strongly, rising to a rolling 10-year real annual return of 5%, and thereby reaching a level approaching the long-term average. Intuitively, this feels about right to us and speaks to the current valuations afforded to equities. While equity markets are no longer cheap, following the 175% rally since the 2009 low point, they are also not particularly expensive, unlike in 2000 when the rolling 10-year real annual return ascended to an unsustainable 16%.
Given this relative equilibrium, the inevitable question that follows is, are investors overly optimistic at the moment – with another asset bubble in the making? We do not believe this to be the case at present. Using the US as a proxy, while equity prices have certainly risen a lot in the past five years and retail money is again moving into equity markets, there is no flood of irrational buying. Yes, net flows into US domestic equity funds so far in 2014 have exceeded the total inflows for 2013, thereby confirming the reversal of the outflows from equities as an asset class. But at approximately $20 billion for the quarter, the figure hardly dents the massive $810 billion of outflows from equity mutual funds from 2009 to the end of 2012. It is our view that investors generally remain cautious, with much media coverage showing evidence of lingering scepticism and focusing on the risks of potential bubbles, often emphasising the potential negative factors rather than indulging in euphoria-inducing good news.
It seems to us that the US equity market is quietly and steadily climbing the so-called ‘wall of worry’, as has been the case for the past several years now. It remains a truism – in our opinion – that market commentators generally regard it as more intellectually satisfying to be bearish, as opposed to presenting positive scenarios. The list of potential hazards is by definition limitless, and forecasting previously not thought of risks can of course be the big break in a commentator’s career – lucky enough to highlight such a risk, given of course that it eventuates. The point is that there will always be potential risks that could undermine equity markets. Our role is simply to maintain the correct perspective as to whether equity markets are currently pricing in way too low a probability of any setbacks. Despitea number of concerns, the constructive case for global equities remains supported by prospects for stronger global growth in coming quarters, accompanied by largely very accommodative monetary policies. Negative short term data issues aside, some trends are still quite clear. First, there appears to have been an impressive pickup in business equipment spending globally in the fourth quarter of 2013, with JP Morgan putting the category at an annual growth rate of close to 10%. A fact that may also explain some of the buoyancy in PMI surveys for manufacturing in recent months. Second, many economists believe that the elements remain in place for a gradual acceleration in global final demand this year, with fading fiscal drags in the US and Europe, combined with robust financial conditions and improved business sentiment and profitability. The case for improved volume growth from US- and European-based companies looks to be at its most positive for some time. This will, in aggregate, lead to growing revenue and profit streams from the corporate sector.
Regarding valuations, global equity markets still seem reasonably valued, with the MSCI World and MSCI Emerging Markets indices trading at 15.2 and 10.5 times forward earnings respectively. This does not point to equity markets that are irrationally overpriced in absolute or relative terms. Thus equities still continue to offer attractive earnings yields relative to government bond yields and cash.
A key factor that should not be ignored is the massive divergence in returns from developed and emerging markets. Since the start of 2013, this differential now stands at 30% in favour of developed markets. However, taking a longer snapshot over the past five years, the returns are almost identical. While it is true that emerging market indices are notoriously narrow – thereby not accurately representing the makeup of the underlying economies – the recent underperformance from emerging market portfolios has been marked. The recent emerging market sell-off intensified when non-resident investors realised they were holding larger than usual interest rate risk in emerging market currencies. Sharp currency depreciations also reminded them of their exchange rate exposures.
A major underlying reality is that exports to developed countries have disappointed, with the result that emerging market economies remain vulnerable to market turbulence. Weakened currencies in 2013 were expected to boost exports to recovering developed market economies, thereby repairing the frailty of those vulnerable economies troubled by current account deficits. Unfortunately, most emerging market exports have been anaemic at best this year, with year-on-year growth of only 4% and little to suggest a significant change in the near future. In the US, for example, there is evidence to suggest that non-energy import growth has been considerably weaker than at any stage of the US economic cycle since 1980. At the same time, the persistence of the eurozone’s current account surplus suggests that prospects for a sharp increase in import demand are weak. The problem with the US and EU demand, it appears, is that it has not yet broadened to include, for example, electronics, which account for 30% – 60% of total exports from a number of Asian economies. Simultaneously, the spectre of weakening Chinese imports of iron ore, copper and other resources create problems for countries such as Brazil, Indonesia and South Africa. In the shorter term, our sense is that the risk remains to the downside of their collective growth target. This is also signalled by Goldman Sachs’s January financial conditions index for China which was close to 1.5 standard deviations below its long-term average. A similar financial conditions index by Bloomberg for Asia ex-Japan also remains around 1.1 standard deviations below its long term average, indicating moderately slower growth. Given the stress afflicting China, it seems even more crucial that a strong upsurge in US, EU and Japanese demand for emerging market exports will soon materialise. It should, however, be recognised that the recent underperformance of emerging markets – as highlighted above – has made the sector’s valuations look increasingly compelling.
The risks created by the withdrawal of liquidity by the Fed are not confined to emerging markets. Overall financial stability risks have probably increased. The huge issuance of low-yielding long-term debt by governments of advanced economies over the past five years means that portfolios holding such bonds are carrying extremely high interest rate risk. Much of this exposure is with financial institutions such as pension funds, banks and insurance companies, whose reaction to a larger than expected rise in interest rates could add to market pressures. In addition, carry trades remain cheap; this has inevitably tempted some investors to take leveraged positions in risky assets. At present, markets believe short-term rates in the large advanced economies are likely to remain close to zero at least until the end of this year, and then rise only gradually. But for how long will markets continue to believe this?
A number of central banks have been making forecasts of their own policy rate for some years. A recent study showed the forecasts to be good for two quarters ahead but are less reliable beyond that. Of particular relevance to the current situation is the finding that central banks under-predicted increases in the policy rate in the early stages of an upturn. While their monetary policy framework had not changed, stronger than forecast macro-economic developments led them to move the policy rate sooner than expected. A further uncertainty is how central banks will seek to shrink their balance sheets when, as we believe it will, the recovery in the developed world economies gathers strength. The more quickly they choose to sell assets, the more spreads on longer-term debt may rise.
The decision on when and how to shrink their balance sheets will not be an easy one. An important consideration is that the main counterpart of increased central bank assets is massive bank reserves. Either these will have to be reduced, or rates payable on them will have to rise in line with policy rates. Either route will take us into more difficult territory. The problems of trying to normalise monetary policy after the long period of aggressive and unconventional expansion will be difficult to solve.
As previously stated, look out for bumps ahead. That said, as an asset class we continue to believe that equities will offer the best protection in the coming years – provided you have a sufficiently long-time horizon and a higher degree of risk tolerance than was the case over the past year or two.