June 2013

INSIDE VIEW: The curious recovery in global equities

GirlIn the current cycle, consumer goods have offered some of the best equity returns. Olly Russ at Argonaut Capital Partners reports

The first quarter of 2013 was a good one for equity investors.  Globally, returns were in the order of 7%, with the S&P 500 rising recently to a fresh all-time high. It would be tempting to see in these returns a normalisation of markets, and a concomitant return of risk appetite. However, this is not an ordinary recovery, at least not in the way we have understood recoveries over the past 40 years. Asset prices have been bolstered by an exceptional round of money printing by the world’s major central banks.  Some $10 trillion (€8 trillion) has been created since 2008, and we are likely to see further rounds, with the Bank of Japan becoming increasingly active.

In a normal cycle, equity values might well increase as economic – and therefore earnings – momentum picks up.  Yet equity buyers have been particularly selective over the areas of the market in which they invest.  Given the high-level figures, one might suspect that more cyclical areas would have done well – but this is not the case, especially in the eurozone.

Societe Generale recently published a study comparing sector returns over the course of the 2003-2007 recovery, and the present one. Then, basic materials, utilities and industrials led the charge. This time round, the basic materials sector is beaten by consumer goods, and is only slightly ahead of Healthcare – with the more regulation and tax sensitive areas of utilities and telecoms disastrous compared with the last stock market recovery.

The last recovery was looking forward to the Chinese investment boom and associated commodity surge – but with much of this behind us now, it is more difficult to see what will power global markets much higher, beyond weight of money arguments.

The first quarter of 2013 is even more stark; the Bloomberg 500 Pan-Europe index delivered 5%, with consumer products returning more than 15%, and Food and Pharmaceuticals both returning 13%. Meanwhile, steel fell 17%, with metals and miners not far behind at a loss of 11%, hardly the sector dominance one would hope for if a sudden economic upswing was not far away.

Looking at the other half of the investment world, however, we see that normalisation is still a long way off: the US ten-year is yielding 1.68%, and the UK 1.64%, just 20 basis points off its all-time low. Meanwhile, the German ten-year is just a few basis points off all-time lows at 1.20%, while the French equivalent is actually at fresh record lows.

What is hard to disentangle is whether the excessive global money printing is artificially pegging these yields at these low bases, or if in fact they signal further poor economic news.  After all, many of them were higher throughout most of the year, when the printed money was already in existence.

What is perhaps new is that economic momentum has drifted lower in recent weeks. Looking at the Citi economic surprise indices for Europe and the US (which compare actual data points to market expectations) we see weakening lines for both.

On the other hand, one feature of markets, for the past few years now, has been that economic cycles seem to be compressed into single calendar years. That is to say, the new year normally starts with a burst of economic and stock market enthusiasm, with gloom beginning to gather by spring. By summer there is widespread talk of double-dip recessions, before surprising economic strength leads to a positive final third of the year, the economy’s worst fears turning out to be unfounded.

This backdrop is punctuated by sudden random shocks, such as the Italian election result, the Cyprus fiasco and now increasing tensions in the Korean peninsula, with an added dose of bird flu.

All of this leaves equity investors pondering what to do next. Global strategists seemed united in calling two investment themes for 2013: everyone out of bonds into equities, and second, everyone out of US equities into Europe.

There is evidence that the switch out of the 30-year bond bull market has begun. In February, for example, US investment grade credit saw the largest outflows on record, albeit small in the context of the bull run.

As for the geographic switch, although European equity inflows are strong, they are perhaps not noticeably stronger than US inflows, suggesting little direct switching, but a general flow into equities.

However, with sovereign bond rates falling, will even this last much longer?

Perhaps this switch from bonds to equities goes some way to explain the sectoral performance of stocks. Money shaken free from the bond market looks for its natural habitat of reasonably safe, yielding assets. This happens to be the high-quality, food, beverage and pharmaceutical type names with which the European market is well-supplied. Former bond owners exploring the riskier world of equities might indeed herd into these names.

Few now probably want to cut their exposure to equities, given their still attractive yield characteristics and relatively modest valuations, especially in Europe. Equally, few probably feel that comfortable about heading towards the higher beta, cyclically sensitive names.

In a world where government bonds seem to be positing low economic growth and offering a commensurately low yield, certain types of equity do offer the prospect of at least some growth, while paying substantial yields to those who are prepared to wait. Besides, their generally more defensive business models look robust enough to produce growth even if the economic situation worsens. It is perhaps little surprise that in this recovery, the less exciting names are the most sought-after.

Olly Russ is co-founder and fund manager at Argonaut Capital Partners

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