Optimism maintained

By Noel O'Halloran (CIO), Monday, 7th October 2013 | 0 comments

I remain upbeat on the outlook for global equity markets and at this point am not proposing any material changes to the ”positive” positioning in place for discretionary client portfolios.  The fourth quarter of the calendar year has historically been the strongest quarter for equity market returns.  Since the lows of 2009, much of the strong performance of global equities is due to valuation expansion driven by the extraordinary efforts of global central banks to restore growth, rather than any strong underlying dynamic from economic or profits growth.  In contrast, the next period of returns will be increasingly dependent on evidence that economic growth is accelerating and translating into continued profits and dividend growth.  In 2014 as central banks slowly retrench (led by the Fed) further equity gains will require fundamental evidence of growth rather than central-bank-inspired hope!

Q3 review

Before expanding further on the outlook, I will firstly provide a quick summary of the quarter just ended. After a pause for refresh during the second quarter, the third quarter of the year was a strong one for most assets, with the world equity market rising 6.4% in local currency terms which translated to 3.9% in euros, and the eurozone bond market showing a gain of about 1%.  This translates to a 14.2% year to date return in euros from global equities.  The gains were achieved as increasingly the global economy seemed to be making progress towards a more normal pace of growth: economic data released in the US showed reasonably strong growth, a widely-feared ‘hard landing’ in China failed to materialise, and the eurozone economy officially emerged from recession.  The decision in September by the Federal Reserve to continue without any change to its liquidity creation policies (i.e. the decision not to “taper” its pace of quantitative easing) was welcomed by the markets and emphasised how strongly policymakers around the world continue to pursue “pro-growth” policies. 

Positive outlook maintained

The recovery so far from the depths of the 2008 crisis can be best described as sub-trend with a very gradual acceleration of global economic growth. My continued optimism from here is centred on an expectation that we will see a further strengthening of growth over the next 12 months.  I forecast global growth of around 3.5% in 2014, up markedly from the 2.5% rate seen in recent quarters. While the economic growth outlook is encouraging it is also fair to say it’s in no way spectacular. Global profit growth of 6-8% during 2013 should be followed by slightly higher growth of 8-10% during 2014. As the baton passes from central banks to company profit growth, I expect that equity returns will increasingly be more in line with expected profit growth. This suggests returns over the next 12-18months should be less than achieved during the past 18 months.

Sovereign bonds have finally begun to struggle during 2013 and I forecast this to continue. “Yield rise” finally commenced during the first half of the year and I expect that bond yields will continue to rise as economic growth accelerates and in anticipation of central banks retreating from their current extraordinary positioning.  In the absence of any material acceleration in inflationary expectations, such “yield-rise” should continue to be gradual rather than explosive

Headline risks

Risks to my positive outlook are US politics, Fed tapering, Fed chairman succession and the emerging market outlook

As I write, US politics are in the headlines with the deadlock surrounding the debt ceiling debate a headline risk causing some short term market volatility. My central assumption is that a deal will once again be struck in Washington. Uncertainty and volatility may well dampen short term economic activity levels which in turn may well push Fed “tapering” into 2014 and therefore not something to be expected during the final months of 2013.

One of the major genuine shocks of recent quarters was the Fed’s decision in September not to “taper” or change the pace of “money creation” in the US economy. For many years now, the US Federal Reserve has gone a long way out of its way to carefully manage expectations of its actions. Over the next few weeks the full reasons behind the Fed’s surprising, even amazing, change of policy will become clearer. Until we know more, I welcome this change of policy in a somewhat guarded manner. If the US economy continues grow at a relatively strong pace, there is a genuine risk that the markets will see the Fed as being “behind the curve” in terms of preventing inflation in the future. The bond markets, in particular, worry most about future inflation. So – in this scenario – bond markets could sell off quite sharply and equity markets have a knee jerk negative reaction also. The prospect of tapering becoming a market issue over coming quarters is again likely.

Over the same time period we will also expect an announcement of the successor for Ben Bernanke as chairman of the Federal Reserve. The strong favourite is Janet Yellen who I believe will generally be welcomed by the markets.

Year to date developed equity markets have strongly outperformed emerging market equities. Emerging market equities were hit by outflows during Q2 in particular spooked by concerns of a Chinese hard landing and the negative liquidity consequences of Fed tapering.  I remain optimistic on emerging market equities.  Despite slower GDP growth from some countries, EM economies are still growing at a superior rate to developed economies and their equity markets are trading at large discounts to their developed market equivalents.  By their nature emerging markets are volatile and have historically been associated with periods where investors either love or hate them.

In summary, we remain in the recovery phase of the global economic cycle. To date central banks have been to the fore in aiding the recovery. From this point forward, valuations and profits will become increasingly central to market potential and outlook. As per the charts below, despite the strong returns since 2009 equity valuation remains on the cheap side of fair value.

Headline risks do remain and I expect markets to remain volatile on a quarterly basis. From a client portfolio perspective I continue to focus on higher quality companies, strong cash flow, and dividend paying companies as they should continue to be the winning factors driving stock selection.



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