Worldwide: Investment Outlook - February 2013

Last Updated: 12 February 2013
Article by Jonathan Davis, Michael Quach and Christopher Bates

INVESTMENT REVIEW - A STRONG START TO THE NEW YEAR

Equity markets have begun 2013 with more than their usual bout of New Year enthusiasm, buoyed by an improvement in investor confidence and tentative signs that the global economic landscape may be stabilising.

US

The S&P 500 Index has enjoyed its longest rally since 2006 and finally broke through 1500 for the first time in over five years as improving investor sentiment continues to drive markets forward. To add to the easing of 'fiscal cliff' worries, three-quarters of S&P 500 companies beat analyst forecasts for fourth quarter corporate earnings, admittedly only after expectations had been lowered in advance. The market rally continued despite the market's former most valuable stock, Apple, falling by more than 10% on the back of cautious earnings guidance and concerns about its ability to sustain its past levels of growth. After an anxious end to 2012, political tensions in Washington eased after the House of Representatives agreed to suspend, though only temporarily, the US Federal borrowing limit, also known as the debt ceiling. It gives Congress further breathing space in which to agree a long-term solution to the problem of the rampant US fiscal deficit. The move, seen as a significant compromise by the Republicans, was welcomed by ratings agencies, and removes the immediate threat of a US credit rating downgrade. However an agreement is still needed to prevent automatic spending cuts taking effect on 1 March 2013, so the political risk of further gridlock has not been removed entirely.

The payroll tax hikes agreed as part of the fiscal cliff deal at New Year will also provide a headwind preventing a strong resumption of US economic growth. Nevertheless, investors, consumers and businesses all appear to have started the New Year with renewed optimism that the economy is now back on track. Jobless claims have fallen to pre-financial crisis lows. Retail sales rose 0.5% in December 2012, beating expectations and once again showing the resilience of US households. The housing market, one of the keys to consumer confidence, has meanwhile continued its gradual recovery. It is likely to remain supported by loose monetary conditions and near-zero interest rates. Expectations for the US will therefore be high this year if the trend of positive economic data persists. Valuations in many sectors are looking quite stretched, but have not so far prevented equity funds from attracting more inflows in January than bond funds for the first time in many months.

UK

UK equity markets have made a particularly strong start to the year, despite renewed signs that 2013 is likely to be yet another tough year for the British economy. Provisional data showed that GDP contracted 0.3% in the final quarter of the year as temporary positive factors that had boosted growth in the summer, mainly linked to the Olympic Games, faded. Talk of a 'triple-dip' recession is premature, but with the UK economy, unlike that of many other developed countries, still below its pre-recession peak, policymakers are struggling to kick-start economic growth. The UK's future in the EU will remain in the spotlight after the Prime Minister, David Cameron, announced that he planned to hold an 'in/ out' referendum on UK membership should his Conservative Party win the next election. The threat of a referendum will be used as a bargaining counter for Mr Cameron as he seeks to renegotiate terms for Britain within the EU.

As economic growth is likely to remain weak, and our trade remains heavily exposed to Europe's stuttering economy, the odds are rising on the UK losing its AAA sovereign debt rating in the coming months. Further quantitative easing by the Bank of England is off the table for now. Yet the equity market, with its substantial weighting to companies that operate overseas, has also started the year well. Despite a positive rerating in 2012, UK market valuations still compare favourably to many of its developed peers, including the US and Japan. Gilt yields have crept back up to around 2%, but are still low by historical standards. Combined with near zero interest rates at the bank, it means that demand for income is likely to remain a dominant theme this year. The large amounts of cash on company balance sheets provide a positive support for dividend yields. Small and midcap companies remain relatively inexpensive, and there are tentative signs that the valuations of cyclical and defensive stocks are starting to converge once more. Investors moving out of bonds into equities continue to reach for the perceived security of large companies with secure dividends.

Europe

Sentiment towards Europe has continued to improve as the economic data for the region, while still poor, shows signs of stabilisation and fears about the breakup of the eurozone have receded. The European Central Bank's actions over the last 12 months have brought a period of relative calm that, many investors now seem to believe, paves the way for leaders to get the single currency project back on track. The ECB released data showing that European banks (278 in total) plan to pay back around €137bn of the €1trn in loans issued through the central banks' long-term refinancing operation (LTRO) programme. This suggests that the troubled European banking system is beginning to heal and confidence is returning to the interbank lending market. European financial stocks enjoyed a strong rally in the second half of 2012. The sector includes many companies that are trading at notable discounts to their long-term average. European stock markets have nevertheless lagged other leading markets so far in 2013, partly because the renewed strength of the euro threatens the competitiveness of its leading exporters.

January's flash eurozone Purchasing Managers' Indices (PMIs) provided some encouraging data that the region's economic climate appears to be stabilising. Although still in contraction territory, the gauge of eurozone manufacturing rose for the third month in a row with Germany's manufacturing index registering an expansion for the first time in ten months. The divergence in performance between the stronger nations of the north and the periphery, where economies continue to contract and unemployment continues to rise, is still marked. The 0.6% fall in Spanish GDP in the fourth quarter was a stark reminder of the fragility of many European economies. GDP in Spain is forecast to decline by 1.5% this year, and although bond yields have come down, a bailout request triggering the ECB's Outright Monetary Transactions (OMT) is still a possibility. This is unlikely to happen until after the German federal election later this year, when the political direction of the eurozone becomes clearer. While the structural issues in Europe remain, equity market valuations look attractive on a relative basis and if the evidence of the economy bottoming out persists, it could further improve investor sentiment towards the region.

China

Encouraging fourth quarter GDP data has helped sustain high expectations of the Chinese economy in 2013. The Chinese equity market has risen by nearly 5% already this year. Growth of 2% in the final quarter meant full year growth in 2012 came in at 7.9%, beating forecasts and confirming that the economy had bottomed in the third quarter. Further signs that the economy is on the road to recovery will please both global financial markets and the new Chinese leadership. The recovery appears to have been kick-started by the Chinese Government's focus on boosting infrastructure spending last year and a steady increase in industrial production, which rose by 10.3% in the year to December 2012. We are beginning to see signs that the shift to a more consumer-focused economy is materialising. While exports have been strong, retail sales were up 15.2% in 2012 and sectors such as consumer goods and industrials have performed well. Healthcare, an area the new government has singled out for greater investment, also looks set to grow. Sentiment towards the Chinese property market also appears to be improving, supported by relatively loose monetary conditions. The measure of success for the new government will be when we start to see evidence of wealth transferring from the state to households, while keeping potential social unrest to a minimum. A combination of attractive valuations and government reforms to improve access to equity markets by domestic and foreign investors should be supportive for Chinese equity markets.

Japan

With the Nikkei index climbing over 25% since mid- November on a wave of optimism surrounding Japan's new political regime, expectation of Shinzo Abe's Liberal Democratic Party has been high as he aims to convince global financial markets that his pledge to rein in the yen and tackle deflation will be fulfilled. The results so far have been positive. In January the government unveiled a 10.3trn yen ($116bn) fiscal stimulus package aimed at reinvigorating the economy, claiming it will boost GDP by around 2% and create over 600,000 jobs. The Bank of Japan has meanwhile doubled its inflation target from 1% to 2%. The new target may prove hard to achieve and risks casting doubt on how far the central bank is genuinely independent. A new governor of the Bank of Japan will be appointed in April. So far however, markets have responded very positively, with the yen falling around 15% against the dollar and Japanese equities continuing to rally. There will be pressure on Mr Abe's government to maintain the pace of stimulus and any signs of slippage are likely to produce disappointment in the financial markets. Earnings revisions are however beginning to turn positive and there is scope for upside surprises when Japanese companies report quarter four earnings figures.

Outlook

In the short term equity markets are due for a correction after such a strong start to the year. The next round of American budget talks, scheduled for the next few weeks, may well provide a pretext for some profit-taking. Investor attention will remain fixed on the outlook for economic growth in the US, Europe and China, to see whether expectations of improvement are borne out in the statistics. The latest fund flow data has prompted suggestions that this year may be the start of a "great rotation" out of bonds into equities, as risk aversion declines and investors start to focus more closely on the minimal inflation-adjusted returns available on cash and government bonds. Our view is that this process will be, at best, a gradual one. The recent surge in stock markets from their lows in summer 2012 has undoubtedly helped to boost confidence. However, for this to be justified over the medium term, companies around the world will need to step up their levels of capital investment and demonstrate that they can continue to maintain earnings growth in what remains an environment of easy money but stubbornly sluggish global demand and continuing geo-political risks.

MARKET HIGHLIGHTS

Currency wars continue

Exchange rates have experienced some notable swings in the last two years as policymakers attempt to maintain their country's competitive position in global markets through active intervention to drive their currencies up or down. Notable moves include the Swiss decision in 2011 to deploy a massive amount of its reserves to prevent the Swiss franc appreciating further, Brazil's deliberate devaluation of its currency, the Brazilian real, and most recently Japan's announcement of policy initiatives designed to drive the yen back down after a sustained period of appreciation. The pound fell sharply during the crisis, but since then is one of only a handful of currencies to have stayed within a relatively narrow range.

Confidence and investor preferences

Private investors have been in risk-averse mode for most of the period since the financial crisis in 2008. This is evident in the wildly divergent rate at which funds have flowed into different asset classes. Flows into bond funds have consistently exceeded those flowing into equity funds for almost the entire period, reversing the normal historical trend. For the first time since 2011, however, this pattern reversed in January this year. If that continues, it could mark the start of a more risk-tolerant phase in the markets.

Unemployment, stocks and bonds

Recent years have seen a strong correlation between the unemployment rate in the United States and the relative performance of stocks and bonds. When unemployment is falling (which appears in the chart as the orange line rising), the trend is for equities to outperform bonds (the blue line also rises). The reverse is true: when unemployment starts to rise, bonds do better. The pattern has held since the financial crisis. If the US economy continues to recover, that suggests further equity outperformance may lie ahead. The Federal Reserve has said it will maintain interest rates at very low levels until unemployment reaches 6.5%, even if that risks higher inflation.

MARKET RETURNS

INVESTMENT Q&A - FINANCIAL REPRESSION

Jonathan Davis has been a senior adviser and investment director at Smith & Williamson Investment Management since March 2012. A former journalist on The Times and Economist, he is a regular columnist for the Financial Times and author of several investment books.

Financial repression does not sound very pleasant. What does it mean?

It is an ugly phrase to describe a disagreeable state of affairs, one which unfortunately many investors are experiencing at the moment. It refers to a deliberate attempt by financial policymakers to hold down interest rates below the rate of inflation in an attempt to force people to change their savings and spending habits. The phrase was popularised by the American academic Carmen Reinhart, the author (with Kenneth Rogoff) of a bestselling recent book on the history of financial crises and their aftermath.

But aren't lower interest rates a good thing?

They are for some people. In general lower interest rates help borrowers and penalise savers. What financial repression specifically refers to are periods when interest rates are being set at or below the current and expected rate of inflation - in other words, when interest rates in real terms are zero or negative, as they are today. The consequences are much more serious when that is the case.

Why does that make such a difference?

Essentially because when real interest rates are negative it starts to distort the way in which money is priced and capital is allocated across the economy. For example, there no incentive for anyone to save or keep money in the bank, if they know that by doing so they are sure to become poorer. The purchasing power of money left in the bank inevitably declines if the interest it pays fails to keep up with the cost of living.

On the other side of the coin, it also removes the pressure on those who have borrowed too much - whether they are individuals, companies or governments - to take action to sort out their finances. When real interest rates are kept artificially low, borrowers no longer have to pay a proper market price for their debt. In fact every year that passes reduces the amount they have to repay, as inflation slowly erodes the value of their debt.

Although that can be helpful in the short term, avoiding bankruptcies, repossessions and banking losses, among other things, in the longer term it is not a force for good. Over time it will produce lower productivity, a decline in competitiveness and a host of other economic problems. In effect negative real interest rates gum up the workings of a free market capitalist system. It is no accident that financial repression is usually the result of some serious financial crisis, such as a credit bubble, banking collapse or the aftermath of war.

So there have been examples of this happening before?

Yes, a lot. The UK, for example, lived with financial repression for the best part of a quarter of a century after the Second World War. It started with the Government holding down interest rates as the country tried to rebuild after the war. But it also extended to a host of other measures, such as rent controls, price controls, limits on how much money you could take out of the country and credit controls. There were a lot of ways in which individuals and institutions were constrained from spending money the way they wanted to.

Why then are we having to live with it now?

This time round the decline in real interest rates is the direct consequence of the global financial crisis of 2008. As we can all see now, the great credit expansion that took place in the years after 2000 inflated a huge and dramatic expansion of the use of debt, by consumers, banks and governments alike. Ever since the bubble burst governments and central banks have been struggling to control the fallout. Slashing interest rates has been one of the few readily available tools to prevent their economies melting down under the burden of their accumulated debts.

Is quantitative easing part of this policy response?

Yes, very much so. In the UK the Bank of England, like the Federal Reserve in the United States, has been using QE to pump money into the financial system in an attempt to rekindle economic growth. By buying billions of pounds of government bonds from banks, pension funds and others it has been forcing down the yields on gilts, in the hope that doing so will stimulate bank lending and keep the price of shares and other assets higher than they might otherwise be - blatant market manipulation, really, but by another name.

And is it working or not working?

It depends what effect you are measuring. The Bank believes that its efforts have been successful, up to a point at least, in preventing the country slipping into a 1930s style slump. It is not easy to prove one way or another. True to form, economists are still debating how effective the policy is. But so far QE has yet to produce either a surge in bank lending or a sustained period of renewed economic growth.

The one certain effect it has produced is that interest rates have fallen sharply towards and then below the rate of inflation. While consumer price inflation remains around 2.0% - 2.5% per annum, base rate has remained at 0.5% (its lowest level in recorded history) for more than three years. The yields on most conventional and index-linked gilts are now below the rate of inflation - a classic case of financial repression.

How are investors reacting to this state of affairs?

The most dramatic impact has been on the yields offered by almost every type of investment. Cash in the bank offers a negative real yield. Combine that with falling income from gilts and corporate bonds, and the yield on a conventional investment portfolio (made up of shares, gilts, corporate bonds and debt) has also been falling steadily. It has rarely been as low as this in the past.

Annuity rates are meanwhile at record low levels, hurting pensioners. Anyone who relies on their investments for income is struggling to cope, just as the history of financial repression makes clear is bound to happen. The search for yield has been forcing many investors to shift their money into other assets, even if it means taking on more risk than they would normally prefer to do.

Who are the major beneficiaries of this policy?

Governments and the over-indebted - banks, companies and individuals - are the main beneficiaries. Governments in particular have accumulated record levels of debt. Because it is invariably easier to promise benefits than to cut public spending, inflation has historically been one of the few politically acceptable ways to reduce excessive levels of public debt. Financial repression, or a sustained period of negative real interest rates, may unfairly penalise one group in society at the expense of another. But it is, for better or worse, one of the few policy tools that the authorities know how to use, and which voters appear willing to support at the ballot box.

How long will the current phase of negative real interest rates continue?

Nobody knows, but it will probably be for quite a long time. Historical precedents suggest several years. The Bank of England has pledged to keep base rates where they are for the foreseeable future, and although bond yields have risen somewhat in the last six months, there is no sign as yet that they will move sharply higher any time soon. The worry is that higher inflation will be the inevitable consequence of keeping rates too low, but that too does not yet look imminent. Savers and investors may however have to learn to live with this new world for some time.

THE JANUARY EFFECT

Many equity markets have started the New Year with a positive first month, continuing the rallies that they experienced in the second half of 2011. In one or two cases, including the UK market, January has produced almost as great a return in one month as was achieved in the whole of 2011. It is not unusual however for the first quarter of the year to produce strong returns, only for the market to fall back in the middle of the year.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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