Wishing investors many happy returns
With the S&P 500 exceeding 2007 levels at the end of 2013, the big question for investors is how best to adapt portfolios to a growth environment.
Critical to assessing this growth in equities is to ask whether or not this upswing in markets is indicative of wider economic growth and stability; what the limits are to this rally and, in the light of this, what fixed-income alternatives should be taken into consideration.
Tim Cockerill, investment director at Rowan Dartington, stresses the importance for investors of balancing their portfolios. “It seems unlikely that 2014 will see as good a return as 2013. Last year was very much a re-rating story, one in which the global economy started to look better than it had done for the past four years,” he says.
“Gains to date have been based on a recovering global economy driven by the United States. But the recovery remains fragile and the fact that the US Federal Reserve is only tentatively reducing quantitative easing (QE) underlies this fact.”
European economic growth remains weak with the picture across the region mixed. However, the periphery could surprise, says Mr Cockerill. The emerging markets, which have benefitted from loose monetary policy in the US, are now facing a range of problems. These markets tend to be seen as homogenous, which is wrong; there will be winners and losers, but for now the “bears” are out and the emerging markets look vulnerable to further weakness.
Mr Cockerill adds: “Fixed interest may have a part to play in 2014 and returns could be reasonable, if company results come in below expectations. But if economic growth gathers pace, it will lead to interest rates rising, which will push the value of fixed-interest investments lower.
“In this climate it pays for investors to be cautious and to ensure their portfolios are balanced.”
Investors will become more comfortable with the scaling back of QE, and give more attention to attractive economic and corporate fundamentals
James Butterfill, global equity strategist at Coutts private bank, says the markets’ slightly negative start to 2014, brought on by concerns over even the tentative reduction of QE, would be trumped by “robust” company results and earnings outlook.
“Equities remain supported by a positive economic and earnings outlook – fourth-quarter results season has been positive across the globe and economic data has generally been beating expectations,” he says.
“The US earnings season so far suggests sales will top the previous peak set at the end of 2012 and earnings are set to rise 12 per cent year-on-year. Trends are encouraging in Europe and across the emerging markets too.”
From a global perspective, the strength of the industrial and consumer goods sectors is indicative of a recovering global economy, says Mr Butterfill. Investors will become more comfortable with the scaling back of QE, and give more attention to attractive economic and corporate fundamentals.
This shift in focus will also come with greater discrimination, he says. Equities are reasonably valued in general, the main exception to this being the US market. But even the relatively expensive US market looks reasonably valued compared to bonds. And further upside for bonds looks limited in a broadly recovering global economy.
“Within equity markets, we maintain our preference for Europe, where economic indicators continue to improve, with even some peripheral countries now experiencing an expansion in manufacturing activity,” adds Mr Cockerill.
Eren Osman, senior investment manager at Arbuthnot Latham & Co, says investors are right to question stock market rises and its sustainability.
Underpinned by improving employment and housing market data, Mr Osman says it was evident the US economy was showing clear signs of recovery, allowing the Federal Reserve to ease off its stimulus programme without growth then collapsing.
“Given that a 7 per cent increase in US profits through 2013 does not warrant one of the strongest equity rallies over the past couple of decades, it is clear investors bought into equities based on the expectation that sustained economic expansion will set the stage for accelerated corporate earnings growth in the years to come; the markets paid up for future profits,” he says.
Mr Osman expects the S&P 500 to deliver returns roughly in line with underlying profit growth of approximately 8 per cent, so still holds a favourable disposition to equities, but does not expect investors to pay for further accelerated earning expectations.
“At current valuations, equities remain our favoured asset class; cash still provides a negative real return and fixed income offers little extra, but with the added prospect of a loss of capital in a rising interest rate environment,” he says.
Jan Straatman, chief investment officer at Lombard Odier Investment Managers, takes a more bearish stance, characterising 2014 as another slow year of recovery. He is markedly less enthusiastic about an “anaemic” Europe. He points to an accelerating US and the drivers for growth there.
“However, the risk of a major negative systemic event has subsided and the relatively benign economic outlook, combined with low interest rates and reasonable valuations, indicate further upside potential for equities,” says Mr Straatman.
He also favours equities in Europe. “Despite the region’s less rosy economic outlook, European equities are more attractive on relative valuation measures and because they have lagged US stocks, which now largely discount the recovery,” he says.
Mr Osman maintains government bonds are not really an alternative – flat to rising interest rates and the risk of rising inflation over time mean the outlook is poor. Over the next couple of years, he expects marginally positive returns, but with downside risks.
However, corporate bonds are more attractive, he says, as investment-grade bonds are too interest-rate sensitive and offer insufficient protection, so investors should focus on the more rewarding “crossover area” between investment and non-investment grade, that is bonds rated BBB and BB. Convertibles will be another interesting alternative, as they combine exposure to both credit and equities.
Alexander Godwin, global head of asset allocation at Citi Private Bank, says he expects the recent period of “remarkable” growth to continue in support of further gains on the S&P 500.
“Last year saw strong performance from US equity markets, running somewhat ahead of the pace of underlying profit growth. Over the next year we do not expect this to repeat; instead we believe that markets will move in line with the growth in corporate profits. This will likely mean more modest returns than in 2013,” he says.
There are definitive signs of economic growth in the US becoming more sustainable, says Mr Godwin, as the unemployment rate gradually normalises, while there are encouraging signs that both consumer and small-business credit growth is picking up after a long period of deleveraging.
Mr Godwin concludes: “Given these improving trends, it has been unsurprising that the Federal Reserve has decided to begin the long process of reducing monetary policy stimulus. Last year saw a significant rise in bond yields, as fixed-income markets began to price in eventual interest rate hikes several years from now. We believe this process will continue, with yields continuing to move higher.
“With this in mind, we continue to be cautious on fixed-income markets and believe that equities will outpace fixed income over a 12 to 18-month horizon.”