2013 has been a bumper year for equities. The US Federal Reserve has played an outsized role, nurturing an environment where investor confidence deepens as liquidity in the system expands.
This can be evidenced by the second consecutive year of sizeable price-to-earnings expansion and a reduced sensitivity to macro data. From a growth and earnings standpoint alone, this year has again mostly been one of disappointment.
As is customary in this day and age, investors anticipate global growth accelerating next year. For the time being, we too remain fairly untroubled by the consensus view that with fiscal headwinds subsiding, US growth could advance to 3 per cent in real terms.
The jury is out on whether that fosters a positive backdrop for equities though. After all, 2014 will also likely be an important year of transition for US monetary policy.
Although the timing of any shift is debatable, we expect the thrust of policy will evolve from bond buying towards greater forward guidance.
Having missed the opportunity to begin tapering in September – an event that had become broadly anticipated – markets have since become more speculative. While this represents a headache for the Fed and a risk in the immediate term, we hope they will overlook the volatility we consider almost inevitable and persevere in consideration of the longer-term risks their policies may induce.
Our approach in this environment of the last two years has crudely been one of buying distressed assets with catch-up potential. Whether domestic cyclicals in the UK and US in Q4 2011, or value stocks in Japan and Europe throughout 2012, in general, the strategy has worked well.
Such was the valuation support in each case that we felt these themes could perform relatively well almost irrespective of economic performance.
Today, with bullish sentiment hitting historically precarious readings as most major markets reach record highs, these opportunities are unsurprisingly far scarcer.
The dispersion that existed two years ago between high and low risk stocks in the UK and US for instance, has largely normalised. Similarly, the willingness of investors to give both Japan and Europe the benefit of the doubt has improved radically.
The point is that a change in strategy is probably logical for 2014.
We continue to analyse market internals for evidence of a persistent shift in leadership. Our principles at such turning points are i) stay patient, ii) not to rule anything out, and iii) don’t bet everything on any one outcome.
Recognising the maturity of this cycle, what is likely is that investors will now have to take more absolute risk to generate each incremental unit of return. While that is perfectly normal of the advanced stages of any bull market, it is also indicative of why many investors are found still scaling into risk as the market peaks.
Portfolio management is all about balance. Judging when to focus on the opportunity to make positive returns, and as importantly, judging when the balance of risks is tilted towards the downside. Honestly, we don’t consider this an obvious choice at present.
We have sympathy with some of the well-known bears who have recently felt obliged to turn more constructive in their positioning, if not their beliefs. Their argument centres on the view that the Fed is going to keep inflating this market for some while yet, perhaps ignorant of the potentials costs and risks. But again, balance is critical. Having already enjoyed the ride, this market is beginning to feel very lop-sided.
Robin McDonald is a fund manager at Schroders