In spite of the proximity of the global financial crisis, equity markets have treated investors kindly in recent years. From its nadir in early 2009 the total return of the MSCI World Index in dollar terms has been over 165 per cent.
Last year every major developed market equity index produced positive returns assisted by the tidal wave of monetary stimulus.
Markets did, of course, start from a low base. However, the rally has been largely devoid of material earnings increases and the result is that valuations have increased markedly. The MSCI Developed World index now trades on over 15 times next year’s earnings (using Morgan Stanley’s figures) and this, in turn is predicated on EPS growth of over 10 per cent. These earnings forecasts must now be delivered.
The US epitomises this problem. Having recapitalised its banks quickly and thus far led the global recovery the US now trades at nearly 16 times 2014 earnings and is above some long term valuation measures such as the Schiller PE. Earnings have not kept pace.
Such a disparity, occurring in a year where QE is being gradually withdrawn, has led us to scale back our US equity position although we remain overweight.
In contrast to the US, emerging markets now look cheap. We retain a small underweight position but we did add to this area following the severe set-back seen last year. Whilst some of the signs emanating from China are more encouraging, in general we envisage another volatile year with elections in Brazil, India, Turkey and South Africa.
EM currencies continue to come under pressure both from the withdrawal of QE and as a result of persistent current account deficits.
So where do we see the opportunities for equity investors this year?
In a world still characterised by sub-trend growth and low interest rates we are seeking to invest in economies which are benefitting from supportive central bank policies with improving credit dynamics. This points us to the UK and Japan.
The UK has thus far benefitted from a recovery predicated largely on housing. However recent data suggests that the recovery is gaining breadth and the re-focus of Funding for Lending in November towards business lending specifically is also reassuring. The UK compares favourably to continental Europe. However, we have added to the both areas, moving more overweight in the UK and to a neutral stance on Europe.
The last area to which we are increasing our allocation is Japan.
Whilst it is not a big position in portfolios, with the currency hedged it packs a punch. The extent of Japanese QE as a percentage of GDP is astonishing. Long term, the ‘Third Arrow’ of structural reform must hit the mark to sustain inflation but we take some comfort from Abe’s recent speech at Davos.
Equity market performance can only be sustained by sentiment for so long. Whilst we look to earnings in the US to drive market performance, so too do we look to UK and Japanese companies to deliver in 2014, albeit from a lower valuation base.
Bambos Hambi is head of fund of funds management at Standard Life Investments