Given that 2013 was a strongly positive year for most equity oriented portfolios, it is tempting to conclude that it was a rewarding year for all ‘risk assets’. But this would be a wholly incorrect deduction. The past twelve months in investment markets have been more subtle than that. The fact that developed equity markets – using the US S&P Index as a proxy – rose by 32.4% in 2013, belies the fact that most asset classes actually fell!
In commodity markets the annual numbers present a bleak picture: gold -27%; copper -7%; aluminium -14%; platinum -11%. Even emerging market equities fared poorly, with the MSCI Emerging Market Index down by 2% for the year. Brazil was the weakest performer of the large emerging economies, falling by a massive 27% (in US$). Currency markets followed a similar pattern as emerging currencies tumbled. The most notable casualties were the rand -19%, the Indonesian rupiah -21% and the Argentinian peso -25%. Bond markets also suffered. Again, using the US as a proxy, the bellwether US 10-year government bond produced a return of -5.1%. It is worth noting that the last time the US 10-year bond returned a total return was in 2009. Not surprisingly, as a consequence outflows from emerging market bonds continued unabated during the latter part of the year. To give this context, since 2009 emerging market bond funds have received inflows of US$173 billion, but since June 2013 outflows have been US$45 billion. The result is that some 80% of emerging market bond inflows since the third round of quantitative easing has now been unwound.
Within equity markets (as mentioned above) it was mostly developed equity markets that produced strong positive returns. The outlier, by a massive margin, was Japan which produced a return of 59%, the US market followed with a strong 32%, while European markets in aggregate rose by 21%.
Why was 2013 such a year of mixed and confusing outcomes? The answer, as has repeatedly been the case since the start of the financial crisis in 2008, is intervention – interference from the major central banks, some critics will say. Global central banks have bought US$7.5 trillion of financial assets in the past four years – or US$150 billion (the equivalent of the market cap of Citigroup) every month. The US Federal Reserve (Fed) is faced with the reality that since the trough of the economic cycle in 2009, nominal GDP in the US has risen by 17% versus an average of 40% in the prior five economic cycles. In stark contrast, the US equity market has risen by 150% from the lows – outpacing the average 84% gain in the prior five cycles.
While the Fed has for some time been pursuing a massive US$85 billion bond-buying campaign to stimulate the US economy, it has recently signalled its desire to cut this programme (known as ‘tapering’). And this is what led to the diverse market outcomes in 2013. The dilemma facing investors – and the Fed – relates to the timing of when this will commence. On the one hand, investment markets and risk assets have benefited significantly from this massive injection of liquidity into the financial system. But on the other hand there is the underlying reality that the US economy is steadily improving and is expected to continue doing so into 2014. Just how skittish investors are was highlighted in June 2013, following the statement by the Fed’s chairman, Ben Bernanke, that the Fed would taper its purchases by the end of 2013. It was this announcement which proved to be a turning point in investment sentiment, setting off the episode of rapid risk reassessment that followed. Equity and credit markets were severely jarred. Clearly many investors had not appreciated just how reliant many asset classes had become on the liquidity support provided by the Fed. It was in the weeks that followed when the damage was inflicted on these assets.
Looking at the future, there is no clear or easy prediction for the period ahead, other than it will most definitely be interesting. Bull markets tend to start at a time when most investors still believe that a strong bear case continues to exist, as was the case in early 2009. This is followed by a period when equities grind their way higher while the cynics and bears remain committed to their negative case. Then, at some point, the penny drops and the flow of funds takes over, driving equities to much higher levels. At the end of this phase equities will generally be overvalued.
In attempting to ascertain what investors are collectively thinking as we move into 2014, the chart below provides us with some helpful context. Since the suggestion of tapering in June, there have been significant inflows to developed market equities, averaging at around US$20 billion per month, and outflows from bonds. Equity buybacks by companies have also been at unprecedented levels in recent months, reflecting massive cash build-ups. In 2013 alone, some US$516 billion of equity buybacks was announced – not all of which was spent in the 2013 calendar year.
A look at this chart will raise questions as to whether the recent flows into equities reflect an overhyped expectation of future returns. The perspective since 2008 would suggest not, given that the flows out of equities and into bonds were nothing short of massive. This reversal in trend, it could be argued, is only just the beginning. It is our view that this flow out of bonds and into equities is indeed in its early stages and is set to reverse over a multi-year period. We believe that 2013 will be remembered in history as the year in which the 30-year bond bull market ended and a steady but secular bull market in US equities began.
This statement is, however, predicated on one major assumption – that both recession and inflation remain absent from the major world economies, and that financial markets ‘normalise’ to a large degree over the next couple of years. By ‘normalise’ we mean that economic confidence and growth gather momentum; support from the US Fed is steadily withdrawn; interest rates therefore rise to long term average ranges; and companies benefit through profit growth, thereby propelling equity values upwards. A telling point regarding the US equity market’s return in 2013 is that 80% of the index return can be attributed to multiple expansion – the market re-rating to a higher multiple – and only 20% due to earnings growth.
The key issue here is that, in the US, the corporate sector needs to grow earnings if equity prices are to advance further. Given the experience of 2013, we do not think it plausible to expect a further re-rating in equity valuations without this growth in profits. Cynics will of course point to the fact that US corporate profit margins are at all-time highs. We absolutely concur with this point – profit margins in the US are more likely to fall than rise in coming years. What is needed to propel company profits is greater economic activity, leading to volume growth, rather than ever higher profit margins.
Looking into 2014 and 2015, we continue to have conviction that the risk to forecasting global risk is on the upside. The US manufacturing sector seems to be leading the global upturn. Despite concerns – in response to the government shutdown – that a huge inventory build-up in the third quarter of 2013 would severely impact this sector, job gains and hours worked in manufacturing were strong, confirming forecasts from recent PMI surveys. US manufacturing output now looks to be growing at an annual rate of 4.5%. In terms of final demand, data suggest that the final quarter of 2013 will show retail sales growth of 3%, posting its strongest gain in almost two years.
At the same time, activity data from China and emerging Asia suggest that rising US demand is boosting emerging manufacturing activity. Additionally, China is gaining success in producing growth via domestic consumption, rather than an over-reliance on exports. The bulk of the uplift in emerging Asian production and exports is focused on the technology sector, aligned with a recent gain in US technology imports. Importantly, the technology sector boost appears to extend beyond smart phones and tablets, which have tended to give short-lived boosts to regional activity when new products are launched. In Asia, the positive tone of both Singapore and Malaysia’s electronics exports is encouraging. Recent data have also brought welcome news of a rebound in Japanese export volume, consistent with signs of faster growth in international trade and industrial production elsewhere in Asia. With this gain, Japanese export growth could reach around 10% in the final quarter of 2013. The most closely watched signs of economic growth will be industrial production. The manufacturing PMI, which rose to a four year high in output and new orders in October, is expected to retain these gains in the fourth quarter overall.
We do remain bullish on Japanese equities. Firstly, the Japanese government is determined to reflate its economy and has shown much evidence of this. Among other things, this is via a policy of weakening the yen. Secondly, there is currently US$20 trillion of capital sitting in cash and liquid assets in Japan that has the potential to be allocated to risk assets. The allocation of this capital is now official Japanese government policy. The recent announcement that the US$2 trillion Government Pension Investment Fund will shift its asset allocation (currently 60% in Japanese government bonds) towards international benchmarks is quite possibly the start of a new period of Japanese capital outflow and a weakening yen.
Europe is anticipated to exit from recession into 2014, accompanied by a narrowing of growth dispersion across countries. On some measures, such as the dispersion in measures of economic sentiment, this narrowing has occurred much more quickly than was expected. The German economy is picking up momentum as expected, with its composite PMI rising solidly to levels signalling above-trend growth. It looks as if domestic demand is contributing to the pickup, with consumer spending once again expanding steadily and corporate spending finally recovering from 2012’s pullback. In contrast, the French economy is still battling stagnation. Fiscal policy is a drag, and much skepticism remains about the government’s reform efforts, which look to be weighing on sentiment.
In conclusion, it would seem that the prevailing consensus sentiment is that the near future direction of equity markets lies in the hands of the US Fed. More specifically, this is the Fed’s decision on when to end the ongoing massive liquidity injections. In our opinion this is an incorrect perception. The big sea change in sentiment actually occurred in mid- 2013 on the Fed’s announcement regarding the gradual withdrawal of quantitative easing. It was at this moment that an inflection point was reached, when investors underwent a dramatic reassessment of the type of asset classes that they would choose to hold in an environment of far less ‘easy money’.
The Fed can take comfort that forward rate expectations have responded to its message. While it is true that little tightening in monetary policy is now anticipated by short term interest rate futures until the end of 2014, tapering talk has pushed longer-term rates higher, producing a sharply steeper yield curve. The Fed may be willing to accept a steeper curve as it tapers, reflecting an evolving view about how changes in risk, namely longer duration investments, impact financial risk-taking and economic activity. The key point is that in late December, the Fed announced that it, in response to better economic growth data, will commence the gradual withdrawal of quantitative easing. This did however not surprise investment markets as it had already been well signalled. The collapse in the gold price earlier in 2013, the sharpest since 1981 is, in our opinion, a clear indication that investors have started to discount a normalisation of the US economy, and by implication interest rates and asset allocation.
One caveat, however, is that the slower the growth in 2014/15 (not our view), the greater the risk of an asset bubble. If central bank asset price reflation intensifies via liquidity injections, the likelihood of localised investment bubbles increases.
Investors should prepare themselves for a bumpier ride in 2014 than was the case in 2013. This is an inevitable consequence of the end of quantitative easing. That said, we believe that a number of supportive secular themes will remain in place – the key one being that the rotation referred to above (‘companies are safer than countries’) will continue to underpin equity prices. More than ever, however, equity fund managers will find it tough to differentiate between those companies that will benefit from the prevailing macro themes, both positive and negative, that play out in 2014. Alpha, rather than beta, will most likely be the cause of large absolute equity returns in 2014