2013 is half done and most investors will be fairly pleased with the results so far, despite the recent weakness, most of which was concentrated in June. The trigger for this change in sentiment were the statements that accompanied both the May and June Federal Reserve interest rate decisions, where Ben Bernanke said that the Fed may begin "tapering" bond purchases, thereby starting the process of reversing the huge injection of liquidity that has been a feature since the financial crisis of 2008.
We view the ability to consider removing liquidity as being a positive development – the patient is slowly coming off life-support but the markets have viewed developments somewhat differently, despite assurances from the Fed that any tapering is conditional on a number of economic targets, especially a reduction in unemployment.
Within fixed interest, the sell-off in June was completely indiscriminate, with both the quality and higher yield (including EM debt) ends of the bond market moving downwards sharply, along with everything in between. Similarly, most equity markets were also down, taking the edge off returns for the year to date. Emerging markets didn't conform to this picture as they have been generally weak throughout the period caused by a lack of growth and the sluggish nature of the recovery in their primary export markets. On average, most EMs are down around 10% this year meaning that the valuation gap between EM and developed markets has increased considerably.
Just to round things up, on currencies, the Dollar has been strong against the Euro and sterling, whilst the Yen has been falling as a consequence of 'Abenomics'. Hedge funds have had a respectable six months, for a change, whilst commodities have generally been on a downward trend, especially gold which appears to have lost its lustre, for now at least.
When writing in April, we suggested that there would be a correction some time in Q2 or Q3. Consequently, recent events are not surprising and since we remain generally positive about the equity markets, in particular, the current period of weakness represents a suitable buying opportunity for the longer term investor. However, recent events serve as a potent reminder that the trajectory of many asset classes will continue to be driven by the policy decisions of Central Bankers from Brussels to Beijing more than by fundamentals.
Although the FTSE 100 lost 5% in June, it is still up by close to 8% in 2013, with mid- and small-cap stocks being up 13% and 15% YTD respectively, despite June's sell-off. As with elsewhere, the trigger was concerns over Fed 'tapering', combined with worries about a Chinese credit crunch and the still sluggish nature of the recovery.
Mark Carney has now been installed at the Bank of England and the initial indications are that he will receive a favourable reception. At the meeting held in early July, the guidance issued along with the "no change" on rates caused sterling to fall and the market to rally in an impressive manner. Issuing of guidance used to be the preserve of the Governor of the Federal Reserve but Mark Carney looks like he'll be doing the same at future BoE rate setting meetings.
Some of the forward looking indicators, such as the Purchasing Managers' Index, show that the UK is now on a strengthening trend, no doubt, to Cameron and Osborne's relief. The jobs' numbers continue to impress and the housing market is showing some signs of strength.
Combine an attractive dividend yield and a modest PE multiple of 12x trailing earnings and it is easy to construct a positive case for UK equities. Indeed, our belief is that the market could go considerably higher before the year-end although the summer period is likely to remain volatile.
The run of seven consecutive monthly gains for the S&P 500 Index came to an end in June but the S&P 500 was still up 3% for the quarter and 13.8% for the past half-year, despite the more recent weakness. The cause was the potential slowdown in the Federal Reserve's stimulus programme and both equities and US Treasuries ended June sharply down. The equity markets did actually recover some poise towards the end of the month when the Federal Reserve "clarified" its earlier statements.
In economic news, sales of both new homes and re-sales of existing properties were better than expected, indicating a continued recovery in the housing market. In turn, this is having a positive effect on consumer sentiment as evidenced by continued month-on-month increases in consumer spending due to the multiplier effect that housing has on the wider economy. Slightly less encouraging was a downward revision to the GDP numbers for Q1 but, somewhat perversely, this actually drove the market higher as it would appear to delay the need for any reduction in QE.
The US remains a favoured market for many, based upon the improving fundamentals in housing, increased domestic energy production and the gradual easing of fiscal policy risks. On the downside, weaning the economy off QE will, undoubtedly, induce volatility but these periods are when canny investors will be thinking about adding to their positions.
The European markets had a generally poor June, losing around 5% on average but they were just in positive territory for the quarter and are up around 11%, in sterling terms, for the half-year.
Interest rates were kept on hold, as expected, at the June meeting but Mario Draghi disappointed investors with the tone of the accompanying statement, sending markets down. This is even before the US news on reducing QE. Whilst the Eurozone crisis is not making the headlines it once did, it has not yet gone away. Only recently, the resignation of the Foreign Minister in Portugal caused a sharp upward spike in Portuguese bond yields but encouragement could be found from the lack of contagion into other peripheral bond markets.
This is reinforced by the fact that some sentiment indicators are beginning to improve such as the Eurozone Economic Sentiment Indicator (ESI), which is at its highest level since May 2012. The EC Composite Purchasing Managers' Index (PMI) also rose in June but it is still below the key level of 50, which indicates expansion. Less encouragingly, unemployment across the Eurozone has now reached a new record high of 12.2% with youth unemployment now at 24.4%. In another piece of unwelcome news, Greece is no longer considered to be a developed market by the MSCI and political uncertainty is once again mounting with the resignation of a junior Government coalition member. Despite this, the next tranche of bailout money is expected to be approved.
On a purely contrarian view, Europe is starting to look attractive. For as long as the authorities continue to take the right decisions then only a modest improvement in economic conditions should see a rebound in corporate earnings. So our long-held negative view is slowly changing.
The pace of advance for the Japanese market slowed in Q2 but it still returned 10%, or thereabouts and it is now up by around 1/3 so far in 2013. On the flip-side, in order to achieve those returns, you needed to hedge your Yen exposure as it has continued to devalue against the other major currency blocks and especially the Dollar.
What everyone is asking is whether 'Abenomics' and his "three arrow" strategy can work? So far, the signs are moderately encouraging, with Q1 GDP being revised upwards to 4.1%, annualised, from an initial reading of 3.5%, whilst May's industrial production was stronger than expected, climbing 2% for the month. Other economic statistics support this view, such as manufacturing PMI and data suggesting that wages and income are on the rise, with corresponding increases in consumer confidence and general sentiment.
The Bank of Japan's Tankan Survey, which is a forward looking survey of business conditions, confirmed the trend of gradual improvement, as did other indicators like bank loans and retail sales, so perhaps there has been a real recovery. As far as the market is concerned, it is interesting to note that managers are beginning to allocate to Japan for the first time in many years but hedging any Yen exposure is a prerequisite to maximise the potential returns as the Bank of Japan seems to be determined to further drive down the value of the Yen. Our view is that any investment in Japan still requires a fairly strong stomach but maybe it is a market that will finally be rehabilitated after its long period in the economic darkness.
Asia & Emerging Markets
Asian equity markets ended June sharply lower, as both they and Emerging Markets generally were hit hard by the prospect of less liquidity and a stronger Dollar. This selling was indiscriminate but China was especially vulnerable, with the Shanghai Composite down 14% in the month, 12% for the quarter and is now down 13% so far in 2013. The Asia Pacific markets, ex-Japan, were down 6% for the month, 8% for the quarter and are down around 6% so far for the year.
Part of the issue for the Chinese markets has been the refusal by the Peoples Bank of China to provide liquidity after a spike in inter-bank rates. Although the PBoC eventually intervened, it is apparent that policy will remain relatively tight in order to slow credit growth, providing an additional head-wind for the economy generally. As a consequence, recent PMI readings have been weaker than expected and factory activity is down. Elsewhere in Asia, the markets in the Philippines and Thailand continue to lag after outperforming earlier in the year, whilst the Indian Rupee fell by more than 5% against the Dollar in both May and June, more than offsetting a modest gain for the market itself over the quarter.
The Latin American markets have also found the going relatively tough, with a 9% decline in June, in US Dollar terms, translating into a 16% fall for the quarter, after a relatively flat performance in Q1. Only Argentina is up in US Dollar terms for the year to date.
The story in emerging Europe wasn't much better although Hungary did buck the trend, to a certain extent, on the back of a cut in local interest rates. At some point, probably not too far off, Emerging Markets will become a very strong buy, but momentum remains against investing in this area. As valuations become ever cheaper, so the temptations for investors will increase in comparison to the developed markets.
Yields on core Government bonds were broadly unchanged for the first 5 months of 2013 but, following the meeting of the Federal Reserve in May where the first mention of withdrawal of QE was mentioned ("tapering"), bonds lurched downwards with a corresponding pick-up in yields. This continued following the June meeting of the Fed and led through into indiscriminate selling of fixed interest stocks of any description, i.e. super-nationals, corporates, high yield and emerging market.
There is a certain irony in that Ben Bernanke has been at pains to make clear that these actions would only be taken if, and when, economic conditions improve. In particular, the FOMC is on record as targeting an unemployment rate of less than 6.5% and will take some time to achieve on the current trajectory.
As mentioned, the selling took no account of value and this has created anomalies. For instance, within corporate bonds, sterling BBB bonds on a yield of 5% look attractive once again.It is obvious that the years of making excess returns from bond investment is ending and that a more defensive strategy is likely to be appropriate going forwards. We continue to favour using funds with suitably flexible mandates that are able to take advantage of any opportunities that occur due to increased volatility.
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