Against a backdrop of a slowly improving global economy, the prospects for equities are promising—for the time being, at least. High yield & emerging debt are the preferred assets, though.
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Ever so slowly, the global economy is getting better. For sure, there have been one or two negative developments recently. One example is the surprising weakness of the US economy in the fourth quarter of 2012, when it contracted by 0.1%.
“That is a strong signal of the feebleness of the world economy,” observes Robeco Chief Economist Léon Cornelissen. He adds that fiscal contraction connected to the compromise brokered to avoid the fiscal cliff will dampen growth in the US in the first quarter of this year as well.
But the situation in the US isn’t as gloomy as those developments might suggest. Cornelissen sees underlying signs of an ongoing—albeit slow—recovery there. Consumer spending has done well. So has business investment. Manufacturing indicators have been stronger than expected, the labor market continues to improve and the recovery of the US housing market is striking.
“We maintain our view that the US economy is continuing to expand, albeit at a slow pace,” he says.
“The US economy is continuing to expand, albeit at a slow pace”
And it isn’t just the US where there is progress. In Japan, the government is pushing the central bank to increase its reflationary efforts, while the new prime minister has announced a 10.3 trillion yen fiscal-stimulus plan. Moreover, the Japanese economy will profit from the sharp weakening of the yen.
Growth in China continues to strengthen. And even the eurozone economy is showing some encouraging signs. Yes, it is true that recent forward-looking indicators are still pointing to a contraction. But these indicators are generally improving, signaling renewed strength in Germany, as well as stabilization in Italy and Spain.
The global macro picture in numbers
Moreover, the repayment by Europe’s banks of a larger-than-expected EUR 140 billion of their LTRO funding suggests a further normalization of the financial system.
It is never plain sailing for the shared-currency zone, however. “The continuing outperformance of Germany points to future tensions, especially now that the economic picture in France is deteriorating,” observes Cornelissen. In addition, the current strength of the euro—the loser in the ongoing currency wars—will probably undermine growth in the region.
Positive on equities
But how does this moderately improving picture feed through into asset-allocation positioning? Cornelissen and his Financial Markets Research team colleagues are relatively upbeat on equities—though only for the next few months.
“Equities are continuing to benefit from a global economy that is still muddling through,” says Cornelissen. Indeed, January saw another 2% gain in euro terms for the MSCI AC World Index.
Cornelissen feels that sentiment could well continue to be positive for a few more months. He says that markets are reasoning that negative surprises would provoke further quantitative easing, while positive surprises, which are unlikely, would not hurt as long as growth does not strengthen to a rate that pushes up inflation rapidly.
“This would leave room for the historical “sell-in-May” pattern,” he says. In this scenario, sentiment will remain positive through April and then reality will kick in. A less-rosy view could result from low earnings growth or renewed worries about the eurozone after Germany’s election, for instance.
Although valuation is not a problem, the fundamental support for a more sustained rally is simply not there. “We find it hard to imagine that cheap money alone will be enough to push up equity markets by another 15% in 2013,” he says.
North America is the preferred region in equities
Within equities, North America is the team’s favorite region. Cornelissen highlights the continuing strength in consumer spending and investments that surprised on the upside in the fourth quarter. “We do not expect the recent weakness of the dollar, which has been a drag on performance, to continue,” says Cornelissen.
Emerging markets are neutral. Emerging markets were unexpectedly weak in January, a month when they typically turn in a decent performance, even after some pretty good earnings-revisions data. Despite a number of positives, momentum in emerging markets is disappointing. “As a result, we no longer expect emerging markets to outperform,” he says.
Europe and Pacific equities remain out of favor
The team continues to take a “somewhat negative” view on Europe, thanks to the risk of ongoing economic disappointments, as well as the political risks. “The region continues to be characterized by a huge number of ongoing downward earnings revisions,” adds Cornelissen.
The outlook for the Pacific has brightened, not least because of the Japanese government’s pressure on the Bank of Japan to inflate the economy and drive exports via a weakened yen. But the team remains negative on the region. For now, the depreciating yen and the strong performance of Japanese stocks are roughly cancelling each other out. “We remain cautious, as it remains to be seen if the economy will really improve this time,” he says.
High yield is favored…
Although equities have some short-term potential, they are not the Financial Markets Research team’s preferred assets. Their favorites are high yield bonds and emerging markets debt.
Why so? Cornelissen says that high yield spreads—which fell from 5.0% to 4.75% in January—can continue to decline. After all, high yield does still offer real yields that are unambiguously above zero. Moreover, default rates are likely to stay low. As an example, the US high yield bond market had a default rate of only 1.9% in 2012.
…as is emerging markets debt…
As for emerging markets debt, further spread compression is likely, given that fundamentals are healthy and anti-cyclical policies are in place. Of course, recent performance has been weak. That is because a broad basket of emerging markets currencies depreciated against the euro. But the team remains positive on the capacity of emerging markets currencies to appreciate in the long term, thanks to the solid fundamentals. “Inflation pressures are abating and real growth for 2013 is set to accelerate modestly,” explains Cornelissen.
…but credits’ attractions have diminished markedly
The team continues to be positive on credits. “But our enthusiasm for credits has moderated markedly,” he says. Spreads fell in the second half of 2012 and appear to be having trouble in falling further, while running yields are very low. Even so, he expects no significant rise in credit spreads or government bond yields, and thus still prefers credits to government bonds or cash.
Negative on government bonds
Cornelissen and colleagues thus favor all three types of bonds to developed-market government bonds. Since December, government bond yields have risen by roughly 30-40 bps. “But we do not think that this is the start of a major move in interest rates,” says Cornelissen. That is because the global economy is on a below-trend growth trajectory, there is only a small chance of inflation manifesting itself in the short term, and central banks remain on the buy side.
“Our enthusiasm for credits has moderated markedly”
Even so, “government bonds are unattractive compared with all other asset classes,” he says. “With a “central bank put” on the downside, we expect the outperformance of riskier assets to continue.” Positioning high yield, emerging markets debt or credits against government bonds thus results in a portfolio position that offers a buffer against moderate increases in bond yields.
Real estate is neutral
The outlook for listed real estate is neutral. On the one hand, appetite for the asset class could well continue. In January, real estate was hindered by a rise in bond yields. But as no dramatic rise in yields is expected, Cornelissen does not believe this will continue to have a significant impact on the performance of real estate relative to equities. Moreover, analyst expectations for earnings growth for global REITs are solid (5%) and are unlikely to be subject to the same amount of downward revisions as equities.
The main worry for real estate is the increased valuation relative to equities. “This is not yet an issue for investors, but we are monitoring relative performance closely. If it weakens, it could mean that valuation is starting to play a role,” he cautions.
Neutral on commodities
On commodities, the team has a neutral stance. “We expect oil to trade sideways, but the risks are on the upside of the current price range,” says Cornelissen. That is because further acceleration in the US economy and China could lift oil demand in the coming months, while the ongoing tensions in the Middle East will probably continue to affect the risk premium.
Meanwhile, industrial metals prices remain subdued but could pick up at a more rapid pace in expectation of a rebound in the US economy alongside China.
