By Dominic Rossi, global CIO, equities, Fidelity Worldwide Investment
Equity markets in 2013 are likely to be event-driven, with much depending on the ability of politicians and central bankers to agree deals and make the right policy decisions. While the prospects for earnings growth in most developed equity markets are now more modest, a positive case can be made for a re-rating of equities, yet this is dependent on progress being made against some powerful headwinds.
With major government bond yields likely to stay low and below inflation, institutional investors will continue to seek positive real returns in higher-yielding, income-generating assets and dividendpaying equities remain attractive on a total return basis. The positive case for equities rests on three supportive factors: Equity valuations are reasonable relative to history with P/E ratios of around 13-14 times trailing 12-month earnings. While this is not extremely low, the relative attractions of equities are enhanced when valuations are compared to sovereign and investment grade bonds. We have seen sustained outflows from equities in the last few years, so much so that institutional levels of equity ownership are now at 30-year lows. Equities are an unloved asset class and there is growing scope for a reversal of this trend. Volatility has subsided. The recurrent curse of equity markets since 2008, VIX volatility has often spiked above the 20% level. I have always believed a reduction in volatility is a prerequisite to any re-rating in equities. Encouragingly, the VIX has fallen back to around 15% having remained below 20% since July. While these factors make a re-rating possible, there are some considerable hurdles to be overcome which could prevent it. In my view, there are three key risks facing equity markets in 2013: Lack of a resolution to the US ‘fiscal cliff’ would throw the US and global economy into recession. The likelihood of going over the cliff, and detracting c.4% from GDP, is being underestimated given the ideological divide in Congress. The economic, sovereign and banking crisis in Europe remains unresolved despite central bank promises having had a favourable impact. With politics in peripheral countries becoming radicalised, there is the potential for more flare-ups. Unfavourable debt dynamics and poor economic fundamentals suggest further deterioration is likely. Geopolitics, particularly in the Middle East, could pose a significant and unpredictable risk in 2013, this being the year that the confrontation between Israel and Iran over nuclear facilities is likely to come to a head. Regionally, emerging markets are relatively attractive given their better growth rates and the fact that capital is likely to flow to investments in higher-yielding currencies. Indeed, I expect currency appreciation to be a growing theme in the emerging world given the synchronised balance sheet expansion at developed economy central banks. The Chinese economy is well placed to have a rebound in 2013; inflation has been brought under control and the leadership transition is now out of the way, suggesting policy can be accommodative. Investors appear to have discounted economic growth rates in the 6-8% range and the market should perform relatively better now that these headwinds have passed. In developed markets, the US looks attractive if the fiscal cliff can be successfully navigated. The housing market is recovering, which is a key bellwether for the broader economy, and consumer confidence is also picking up. In energy, the US could become the largest producer of both gas and oil thanks to the exploitation of its shale reserves.
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