With a return of investor confidence equity markets have come a long way in the last 12 months.
Improvement in the real world is in the process of lifting off a low base and, while having been supported by extraordinary monetary policy and fiscal measures, activity has yet to surpass the levels we saw prior to the financial crisis.
The centrepiece of optimism has been the US which, of all the major economies, is showing the most consistent signs of approaching “escape velocity” at which it can return to self-sustaining growth.
However, having experienced the strong advance made by the US equity market there is now an element of waiting to see if the reality of the economic recovery is sufficient to deliver the earnings growth necessary to sustain current valuations.
In the meantime it seems unlikely that the easy monetary policy we have become accustomed to will be removed too quickly. Indeed, the US Federal Reserve Bank recently surprised many market participants with its decision to maintain the rate of asset purchases.
Yet forward guidance has linked policy to clear measures of economic improvement and such clarity that the necessary objectives have been met is only afforded looking back at historic data. Thus withdrawal of such stimuli is more likely to be in reaction to confirmation of positive economic news rather than run the risk of anticipating an economic trend.
In this environment it is difficult to identify a catalyst that will lead to a repeat of across-the-board rises in US equity valuations in the near term.
However, we feel there remain opportunities at stock and sector levels to identify companies with potential for earnings growth and to avoid those more richly valued, so we have switched our passive exposure within the region to actively managed funds.
More recently elsewhere in Europe and Japan we have seen growth momentum pick up in the wake of early signs of improvement in the US economy.
Shinzo Abe’s measures to revive the sluggish Japanese economy have proved effective thus far and rewarded our overweight allocation to the country, which we introduced in December. Now, with the easier wins of accommodative monetary and fiscal policy well underway, it is structural reform that is required to improve Japan’s competitiveness.
This will be a much more fraught, longer-term undertaking for which the outcome is less predictable and we are understandably more cautious.
Similarly, high levels of debt in a number of European countries remain a cause of significant concern, along with structural issues surrounding the Euro, but generally speaking Europe too has been lifting itself out of recession.
This improving picture has led to capital flowing back to developed world economies, putting emerging market and Asia Pacific equities under significant pressure. These flows have been indiscriminate, and the effects exacerbated by the shallow depth to their markets.
In the shorter-term this reversal of capital flows will act as a headwind for those whose asset allocations reflect a belief in the long-term growth potential of emerging market and Asian equities. However, once again, a focus on the outlook for individual companies, rather than broad indices, through active management will cast the opportunity to turn short-term price volatility into an advantage.
Indeed, as growth in developed economies begins to gain traction this should generally prove positive news for equity investors.
Elliot Farley is co-manager of the T. Bailey Growth fund