Silver Linings in 2013?

30 January 2013

Trevor Greetham, Asset Allocation Director at Fidelity

Global stock indices posted double-digit returns in 2012 as Hong Kong and Germany performed best while Japan and Spain lagged. Bond markets offered steady returns as emerging-market debt, high-yield and Italian government bonds performed strongly at the riskier end of the spectrum. But solid full-year returns tell only half the story of what was another roller-coaster year. Stock markets rose, fell, then rose again as policy makers responded to euro stress and weak economic data in the middle of the year. Risk on/risk off will still be with us in 2013 but we are upbeat on the world economy and we expect the trend to favour US and emerging-market stocks.

Four years on from the failure of Lehman Brothers and the investment backdrop is still one characterised by economic uncertainty, short business cycles, knee-jerk policy interventions and, as a result of the knee-jerk reactions, a polarisation of asset returns that is reducing much of active management to a binary call on risk.

The onset of the global financial crisis can be traced back to the 2006 peak in US home prices but it was the shock caused by the failure of Lehman in September 2008 that gave rise to the risk on/risk off phenomenon. Almost overnight a wide range of risky assets moved decisively lower and they have moved almost in lockstep ever since. At the same time, safe government bonds have moved the other way. We see this behaviour as a consequence of heightened economic uncertainty. Sensitivity to violent swings in global growth is drowning out other factors. We expect correlations to stay polarised for years to come, given the indebtedness of major economies and political tensions in the eurozone periphery.

A multi-asset silver lining

While risk on/risk off makes active management more challenging than usual there is a silver lining for multi-asset investors. Low or negative short-term correlations between risky assets and haven investments are improving the diversification benefits to be had from mixed exposure and the four years since the crisis lows have seen good returns for investments of all kinds. Global stock prices have almost doubled since March 2009 and total-return indices in the US, UK, Germany and some emerging markets are at, or are near, record highs. Bond markets have fared well, especially those with exposure to credit risk. Gold seems to have had it both ways – at times a risk asset, at times a haven – rising 250% since 2006 as central banks started expanding their balance sheets.

As uncorrelated short-term trades are harder to find, it is all the more important to express longer-term views alongside those of a more tactical nature. There are important divergences to exploit. With the world economy seriously desynchronised for the first time in 20 years there is a wide dispersion of regional equity returns. US stocks have outperformed eurozone stocks by around 50% since the middle of 2007 and policy differences still lead us to favour the US. Different economies were hit to differing degrees by the financial crisis and policymakers have chosen different policy mixes in response, not all good. Lessons from the 1930s’ depression suggest countries able to foster recovery with sustained easy monetary and fiscal policies stand the best chance of growing their way out of debt. On this basis, the US looks best placed to emerge from its downturn first. Meanwhile, the global financial crisis was just the kind of asymmetric shock 1990s’ euro project nay-sayers warned of and the rigidities of the single currency have been laid bare.

Policy differences matter. A recent IMF study concluded that fiscal tightening during a period of economic weakness can be counterproductive. The “fiscal cliff” in the US is a negotiating tactic whereas in parts of Europe aggressive front-loaded austerity has been a reality. The US will tighten fiscal policy in 2013 but gradually and into a recovery where economic activity is already well above its 2007 level. US property prices are rising, banks are willing to lend and unemployment is falling. In the eurozone, fiscal tightening has been concentrated in the periphery where asset prices are falling, banking systems are fragile and unemployment is hitting record highs. Even in the UK, where US-style quantitative easing has been in force, the economy has failed to muster enough momentum to mount a sustainable recovery. The quantitative easings by the central Bank of England have not offset the withdrawal of fiscal stimulus in the way interest-rate cuts did in the early 1980s.

There is some good news for investors from the eurozone because the first steps by policymakers towards debt mutualisation have reduced the risk of a collapse of the euro. However, the key issue for equity investors is growth and Europe is likely to remain a laggard while austerity is the main policy thrust. Outside of Germany, we would rather invest in emerging markets for exposure to an upswing in global growth.

The end of stop-go economics?

The stop-go application of stimulus has had a role to play in the shortness of economic cycles but we are hopeful that the next upswing will last longer. High thresholds to action have seen central banks and eurozone governments respond to signs of financial stress late but in large size – a kind of financial “shock and awe”. But on most occasions, stimulus has been withdrawn prematurely when political opposition to more debt mounted. The latest rounds of quantitative easing by the Federal Reserve are different. So-called QE3 is focused on the mortgage-backed securities right at the heart of the bubble that burst in 2006. Moreover, the program is open-ended with no preordained end date and there is a commitment to keep loose policy in place long into an economic upturn even if this means inflation overshoots the Fed’s 2% target for a few years.

Domestically generated inflation is just what the world needs right now. Wage inflation reduces the real burden of consumer and higher income-tax receipts help to reduce government debt. A controlled pickup in inflation against an easy money backdrop would be bullish for stocks. Global stocks are cheap relative to government bonds with an implied equity-risk premium of 8% on some measures as against a long run average of 4% and a reading of 0% in January 2000, as the chart below shows. If dot-com-bubble valuations were unsustainable then so are today’s valuations. With Fed intervention likely to keep Treasury yields in a low range for years to come we could see an upward re-rating of stocks.

A US-led recovery in global growth is unlikely to be plain sailing and it could take many years to play out. However, with lead indicators troughing, US and Chinese economic indicators looking good and an easy Fed policy in place, we start 2013 in an optimistic mood. We see commodity price increases, an upward rating of stocks versus bonds and US and emerging market equity outperformance as the most likely outcomes.

The global equity-risk premium proxy since 1990

DataStream. The equity-risk premium proxy is global weighted earnings minus real bond yields.

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