Investment Outlook: Hit me if you can!

By Noel O'Halloran, Monday, 7th April 2014 | 0 comments

In the first quarter of 2014, investors were ‘hit’ by a barrage of macro challenges in the US, China and Eastern Europe, and investors also fretted about whether Japan and Europe were gaining the upper hand in the battle against deflationary challenges. In the US, very severe winter weather was the presumed cause of a significant decline in economic activity.  In China, the economy slowed sharply- leading to expectations of a government stimulus package – and to cap it all the crisis in Ukraine raised geopolitical tensions across Eastern Europe and beyond.

Despite these ‘hits’, global equity market performance proved to be very resilient with the world equity index rising by 1% in local currency.  Europe led the way, with the eurozone index rising 2.8%, slightly ahead of North America, which rose 2%.  Japan was the laggard, showing a decline of 7.5%, while Emerging Markets were down very slightly (all returns in local currency).  In contrast, bond markets (in Europe in particular) appeared to benefit from falling inflation and improved sentiment towards peripheral countries,  and delivered strong gains as the European over 5-year bond index rose by almost 6%.  Commodities were very strong, rising by about 7%, regaining some of their losses in previous quarters.

Hits perceived as transient

It’s very clear, therefore, that markets regarded these ‘hits’ as transient and focussed instead on improved long-term fundamentals.  That is not particularly surprising given that I believe that the current global economic recovery has at least another three years of growth before we concern ourselves about the next economic downturn. The continued slow but steady global economic recovery will prove resilient and continue to demonstrate recovery. I reiterate my strongly held conviction that real assets such as equities and other alternative asset classes are attractive for as long as  global central banks are fighting deflation and downside risks to economic growth. While in the short term such actions also help bond yields, in time recovery will prove a big negative for bonds.

In January, I expected 2014 to be another positive year, with a likely outcome of high single/low double digit returns from global equity markets. This would be consistent with expected global earnings growth for 2014. Equity markets are no longer cheap and are generally now trading at long term average valuations. Therefore, my central expectation was and remains  that returns will be consistent with earnings growth from here out rather than further expanding valuation multiples – though there remains some possibility that abundant liquidity could push valuations up still further. 

What we are watching

As we enter the second quarter there are a number of key fundamentals that we are watching:

  • A key factor will be the upcoming company earnings reporting season. While many US companies (cyclical ones in particular) will no doubt have been hit by adverse weather during the first quarter, their outlook, commentary and guidance for the remainder of 2014 will be very important to markets.
  • At a macro level it is crucial that the US economy does rebound from the weather affected first quarter. I certainly expect it to, having spent some time looking at this issue while in the US recently on a research trip.
  • A missing ingredient from this recovery has been any material sign of growth in corporate capital expenditure. We are at a stage in the economic cycle where many economists expect to see increased signs of such a pickup. This new dynamic would be a positive not just for economic growth but in particular for corporate earnings.
  • Although we have no official numbers yet for the first quarter economic growth in China, it does appear to have been particularly slow. I maintain the view that the economy will not have a hard landing and Premier Li has said several times in the last few weeks that he had means and ways to protect the economy from deterioration if necessary. A natural rebound in growth, or one helped by further stimulus measures by the government would be positive catalysts and further welcomed by markets.
  • For over 12 months now equity market performance has been polarised between strong developed market performance and struggling Emerging Market (EM) performance while EM battled with a number of headwinds. Over the remainder of 2014 I expect this trend to reverse and EM to gain positive traction again. This will have to be driven by a pick-up in both earnings and economic growth.
  • While a rising tide hasn’t to date seen any significant differentiation between US, Europe and Japan, I believe that there is a real chance that markets will challenge this more and focus on whether the latter two are truly synchronised with the US economic recovery or whether they are in fact struggling and deflationary forces are materially different for Europe and Japan than in the US. To date, markets have given them the strong benefit of the doubt but I note that the ECB for example has spent a lot of its recent press conferences discussing what tools they have at their disposal to fight deflation, if necessary.  If the economy is recovering, as the markets believe, why is inflation so exceptionally low?

Emerging Markets

It is worth expanding further on my views on Emerging Markets, as markets are very focussed on that topic.  As I stated above, I believe they will begin to converge again with Developed markets, and for those looking for a ray of hope, Emerging Markets had a significant outperformance over recent weeks. At a fundamental level while challenges remain (growth and politics) across various emerging markets, I believe we are well past the worst and that the key catalysts of economic growth and earnings growth  will help over coming quarters.

It’s important to note that investor sentiment and positioning is very poor towards EM. This is not at all unusual as historically investors either hate or love emerging markets with seemingly no in-between state! Any investor with a grain of contrarian instinct would be looking to buy EM and particularly as valuations are well below historic averages. This is also against a background where some argue that many investors are increasingly ‘in love’ with developed markets such as the US. At a fundamental level, although challenges remain, EM economies are in a much healthier state than they were ahead of the 1997 Asian crisis and I do have confidence that the Chinese will manage the rebalancing of their economy without a hard landing.

Investment markets remain as dynamic and challenging as ever. In this quick blog I have summarised some of the major drivers we will continue to focus on during the second quarter. Within markets and for your portfolios we are also managing both sector and style volatility. By style I mean whether for example value, growth, momentum or yield are performing best and we have noted more volatility in styles over recent months. Consistent with a slow but steady recovery in global economic growth we continue to believe that stock picking should remain concentrated on companies with strong balance sheets, positive earnings guidance and a strong attention to cash flow and dividend payments. The bottom line remains that I expect 2014 to be a solid if not unspectacular year of returns for investors despite the headline challenges.

Noel O’Halloran, Chief Investment Officer

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