The media has recently been awash with reports that a great rotation has begun in the markets, suggesting that investors are quickly beginning to unwind their positions in the bond markets and back into stocks.
Proponents of this theory cite, among other things, the FTSE’s best January since 1989, and the largest four-week inflows into US-based stock mutual funds since the height of the dotcom boom.
However, while equities have seemingly flown out of the starting blocks in 2013, it would be unwise to place one’s money on the equity market ‘hare’ without studying the running conditions, or the strength of his opponents. Data also reveals that money continues to flow into bond funds, and the start of this year has been complicated by uncertainties due to the US fiscal cliff.
Much, naturally, rests on the route that global economic growth follows – as equities and other risk assets tend to benefit when momentum builds in the early growth phase of the economic cycle.
While expectations for global expansion in 2013 have been pared back, which might not seem particularly positive, this does however create room for the markets to be pleasantly surprised.
Some economic indicators have started to show signs of improvement, notably Chinese purchasing managers’ indices, and US manufacturing activity and housing data. These observations appear to link neatly with the recovery in global real money growth in the second half of 2012, which usually leads economic expansion by about six months.
While monetary trends suggest that growth will peak in the spring 2013, they are not signalling a big slowdown. The global economy could continue to ‘jog’ along gently, which could be the best outcome for equity markets.
One potential threat to this benign outlook for equities would be if growth recovers too quickly, leading to a rapid rise in government bond yields in response to expected monetary policy tightening.
Turning off the stimulus taps and expectations for a rise in interest rates could frighten investors and precipitate a sell-down.
Similarly, we can’t fully discount the tail risk of a fresh crisis: the US continues to push out the deadline for dealing with its debt ceiling, while politics are likely to prove the key to stability in Europe.
That said, even with their recent gains, we believe that major equity markets are still priced to reflect numerous hurdles that the world faces today. Companies have continued to repair their balance sheets, cash balances are strong, and we expect dividend payments to continue to rise.
In a world of ultra-low interest rates, the search for income that will outpace inflation is becoming increasingly hard, so the trend of investors seeking dividend-paying shares will likely continue.
Similarly, with high quality government bonds now offering little value except in the most deflationary scenario, ‘top-end’ high-yield corporate bonds that produce a ‘reliable yield’ appear the more attractive option.
At a time when markets are tending to move closely in step as investor sentiment swings from risk-on to risk-off and back again, we are spending significant time debating and analysing risk exposures, ensuring we have the right balance of assets in our portfolios should sentiment turn again: in this respect, investing is a marathon that demands careful preparation and steady progress, rather than a mad dash towards the finish line.
Bill McQuaker is head of multi-asset at Henderson Global Investors