By Chris Wyllie
April was groundhog month, repeating the pattern of weakening economic data seen in 2011 and 2012. As in those years, commodity and bond markets took note, the former selling off and the latter rallying. However, global equities took it in their stride. This was also similar to previous years, when US markets in particular were unfazed by what they saw (at first), but this time even growth sensitive emerging markets were only slightly weaker (in sterling terms) and more than offset by the meteoric Japanese market.
The only major mishap – and fortunately one we were able to avoid – was in gold. The question now is: will May be groundhog month too, with a sudden reality check on growth triggering a correction in equities?
Our ardour for markets has been cooling since February when we observed that investor sentiment had swung to the point of becoming rather bullish, which is often a sign that the best returns are behind us. Since then some of our other indicators have shifted in a more cautious direction.
Economic data has surprised firmly on the downside pretty much everywhere except the US, where it has been just mixed. In recent years this has been a reliable indicator of tougher times ahead. At the same time we have had to move back to a neutral score on equity valuation, because equities are no longer cheap due to prices continuing to edge higher even as earnings forecasts have dropped, stretching the price-to-earnings multiple. US equities are actually now towards the expensive end based on long-term measures.
Finally, some recent price trends have been unsettling. Commodity prices – particularly in industrial metals and oil – have been very weak, taking out important support levels. This may say more about supply than demand – and ultimately cheaper input costs are good for the world economy – but it is also possible that it is telling us that growth is more fragile than we think. Emerging market equities have meanwhile been testing price support levels. If these break decisively then it is likely to unleash more selling pressure.
Despite this generally more downbeat tone from a number of our signals, few are outright bearish and, most importantly, there is no warning klaxon from our growth models, which remain on green (just). Overall, they suggest that a mild global acceleration is still in train. We expect the US to lose momentum – which may disappoint some – but for Europe to start to pull out from its nosedive. We have seen some data confirmation of the former, but so far not the latter, which is a little unnerving, but hopefully it will start to come through soon. If so, we would likely see a return to the conditions of the second half of last year, with European equities outperforming.
Returning to our question – will May deliver an equity market sell-off, for the fourth year in a row? Perhaps the biggest reason why it shouldn’t is that it is just too predictable. The fact that equity investors have looked past some pretty weak data points recently seems to indicate that they have learnt not to ‘buy the dummy’ and get spooked out of markets at the first sign of trouble. Faith in the ability of the central banks to underwrite the economy remains strong, for now at least.
For our part, we believe the risks to the downside have increased but not to a degree to require major defensive steps. Given strong returns year to date, we have chosen instead to dampen volatility by stepping down from a 5 to a 4 out of 10 on our risk scale, paring back equities to just below 40% and adding to government bonds. These changes were made in mid-April. This leaves us with a moderately growth-oriented portfolio which accurately reflects our assessment of risk and reward as we approach the squally summer months.
Chris Wyllie is chief investment officer at Iveagh
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