By Shaniel Ramjee
Anyone looking at the performance of financial assets in the opening months of 2013 would be forgiven for thinking that many of the issues plaguing economies around the world had been solved. In truth, while central bank policy has coaxed asset markets higher, there is still much to do.
It would be remiss to say that things aren’t getting better. The US banking system continues to improve, allowing the cogs of the US economy to turn once again. Household balance sheets are healthier, with housing on a surer footing, and employment increasing. Much hope rests with the spending power of the US consumer.
Yet, there remains a serious problem, and it can be seen in the reduced contribution of corporates to the US economy. Many are choosing to return capital to shareholders over making investments, as a consequence of the tepid rate of growth prevailing across much of the world. With Europe dragging behind and China entering the process of transition to a more balanced economy, even the extraordinary monetary experiment conducted by the Bank of Japan is likely to get the world to average growth at best. Perhaps the best way of explaining what we have seen in markets is to return to quantitative easing once again. One of the main effects of this type of unconventional monetary policy, as already noted by a number of central bankers, is to suppress the returns of “safer” assets down to unattractive levels, diverting investors towards assets further along the risk spectrum. It’s not hard to see the outcome of this “portfolio balance” effect. Many bond investors now find themselves in peripheral Europe, emerging markets and high yield credit, while asset allocators have embraced equities so far this year.
It is instructive to look at the progress of the equity market in the US in more detail. With the recovery centred around financial and consumer health, a strong relative performance from those sectors of the equity market isn’t surprising. Furthermore, the search for yield – and change in valuations of income generating assets as already noted – has also made the more stable, cash generating companies relatively more attractive for investors.
The unavoidable question, of course, is how much longer this trend will remain intact. It seems intuitive that, as an economic recovery is underway, the more economically sensitive areas of the market such as Materials and Industrials should lead the market. Curiously, however, this has not occurred.
A historical perspective suggests that during periods of relatively low growth and low interest rates, there has been sustained outperformance by sectors regarded as having “defensive” or “quality” characteristics. These periods are characterised by multiple expansion of these sectors, as investors demonstrate that they are prepared to pay more per unit of earnings from more stable areas of the market.
Looking across financial markets more widely, it is clear that investors are highly sensitive to the liquidity provided by central banks. Talk of “tapering” the level of quantitative easing, “adjusting the dial”, or even the high levels of government bond volatility we have, seen inject a level of uncertainty into an environment where investors had become certain that central bankers would do what it takes. Somewhat perversely, the return of healthier economic growth and a more normalised monetary environment would probably be accompanied with higher financial market volatility. While we expect improvement generally, however, challenges persist in many areas of the global economy. Unconventional monetary tinkering is, therefore, likely to become a permanent part of the central bank toolbox.
In the context of global assets, we remain constructive on the equity market, particularly in areas that have a better earnings outlook. The key catalyst for a broader, more traditional cyclical rotation in equities would, however, be corporate investment. Although this has not materialised so far, its absence has not precluded the market from moving higher.
Shaniel Ramjee is investment manager, global multi-asset group at Baring Asset Management
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