The first quarter of 2011 saw world equity markets rise in local currency terms (the MSCI World Equity Index rose by 3.7%), although the strength of the euro against many currencies eroded those gains when translated into euros. Looking into the second quarter, my central thesis remains similar to what I wrote at the beginning of the year. I then expected a continuation of the sustained but bumpy economic and equity market recovery, and particularly so for the first half of the year, and I stated my belief that the second half of the year would be tricky. I retain those views.
The first quarter has been reassuring from a fundamental perspective with a very solid economic performance around the globe, excellent growth in corporate profits and increased signs of confidence displayed by corporate management via increased dividends, share buybacks and a big pickup in M&A activity. These fundamentals supported particularly positive equity markets through January and much of February, with bond markets under negative pressure. During March, however, the markets were hit with two new crises: the political eruptions in the Middle East and the powerful earthquake and deadly tsunami in Japan.
Two new crises
The political unrest in the Middle East and North Africa led to a large increase in the price of oil, to above $115 per barrel. We believe that the unrest will maintain oil prices at elevated levels, but not at levels high enough to choke off the global economic recovery. If however the crisis were to impact on Saudi Arabia in a meaningful way, we would then have a fundamentally different concern, because of its dominant position as a global oil supplier.
The tragic events in Japan led to concerns about the impact on Japanese and global growth. We believe the earthquake will have minimal impact on global GDP growth and will have more specific impact on certain sectors that may be affected by supply chain disruptions. Near term economic releases in Japan will suffer but should be compensated by a strong rebound later in the year as rebuild commences.
Despite these external shocks many clients are positively surprised by the resilient performance of global equity markets for the quarter, in local currency terms.
The ECB surprised us
Closer to home the continuous debate surrounding the Euro zone fiscal crisis, Ireland and its banking system and fiscal woes are not a major surprise to us. The markets have debated and hoped for a “Grand Plan” for Europe and at the time of writing could conclude that at this point we remain closer to a “Great Mess”! Our main assumption is that this crisis will remain firmly in the headlines for months to come and that the effects will remain for the next 5-10 years.
What has been a genuine surprise is that despite the above “mess” and struggles in peripheral economies, the ECB seems set on raising its key interest rates at its April meeting and indeed seems intent on raising rates further later in the year. At a time when many are concerned about finding solutions for the last downturn the ECB is intent on fighting the next bubble….early!!
Against all the negative headlines about Europe, the move to raise rates sooner than other global central banks has led to the euro strengthening by 5% versus the US$ and almost 3% versus Sterling over the quarter. This strength in the currency was a surprise.
Looking ahead into Q2: further potential for gains
I remain constructive on equity markets and believe we have further upside over coming months:
· The global growth background remains supportive, developed economies have gained economic traction and emerging markets remain very healthy
· Earnings growth remains very strong and reassuring
· Companies are willing to spend
· Despite gains to date, market valuations remain undemanding
· While governments and consumers remain cash strapped, company cash levels are at record highs and the greatest takeover boom in history could be ahead of us in coming quarters!
But watch the Federal Reserve
The key tactical challenge to the positive factors above for me will be the rhetoric and expected actions of the Fed. From a global markets perspective it is the Fed (not the ECB) that matters and its actions dictate the short term market direction in my view. As an example, look at the very strong markets that we saw during and after September when the Fed poured fuel on the fire with their new quantitative easing programme (“QE2”).
To date the Fed remains at polar opposites to the ECB, with the former still concerned about solving the last downturn and some argue risking inflation or “bubbles” for the future. The Fed in its statements remains pragmatic and cite, for example, the debt deleveraging overhang on the economy, elevated levels of unemployment, and the weak housing market. It generally dismisses concerns about inflation. Thus the Fed keeps rates low, its rhetoric is soothing and that, combined with excellent micro company fundamentals, has been a positive cocktail for the markets.
The danger into the second half of the year and especially as the economy gains traction is that as the facts change, so will the Fed. It remains likely that the Fed won’t raise rates at all in 2011, but that’s not to say that they won’t start rowing back their QE2 programme and start talking about raising rates. That is the tricky phase for global equities. From a currency perspective this should be the point when the US Dollar begins to strengthen again, against the euro and other currencies.
At KBI Global Investors we remain actively focused on these and the many other issues that are driving markets and market volatility. Our central scenario remains constructive to risk assets clearly, but not blindingly so. Markets remain extremely volatile and we expect such volatility to remain, not least induced by surprise events such as described above. In such a scenario, we remain convinced that themes such as focusing on corporate strength, strong cash flows and positive earnings momentum remain winning strategies. As earnings growth momentum fades we continue to emphasise what - to some! - may be a quaint relic: dividends and dividend growth! We believe that dividends will constitute an increasing percentage of total return over coming quarters.
I continue to believe that away from banks, central banks and governments, the corporate sector will compete for media headlines with their various actions geared at shareholder return, not least through M&A.