The stronger appetite for risk continued into the first quarter of this year, only temporarily derailed by the upheaval in the Middle East and the Japanese earthquake, tsunami and subsequent problems at the Fukushima nuclear reactor.
Upward revisions to growth estimates for the US and some European economies due to higher corporate earnings and a more sanguine outlook for the euro were contributing factors. The hope that the European sovereign debt crisis may be controlled with the announcement in March of the expansion of the European financial stability facility may also have had some influence on sentiment.
Factors that were pushing risky assets higher, particularly equities, should stay in place (notwithstanding short-term concerns in Japan and the Middle East situation), with corporate profits moving in the right direction, abundant liquidity, low returns on cash and last but not least the underweighting in equities by institutional investors.
In the short term though, we see potential headwinds in Japan – nuclear uncertainties are difficult to quantify but do justify a rise in the risk premium on Japanese assets and a rise in volatility. That said, the economic impact outside of Japan should be more limited, although the necessity of savings repatriation to enable financing reconstruction could support a strong yen. The Japanese are also the biggest buyers of US treasuries and with QEII coming to an end in June, the question remains as to who is going to buy billions of dollars worth of debt.
The geopolitical situation in the Middle East has had a limited impact on financial markets so far but there is still a risk of a domino effect into other countries in the region, especially if the price of oil keeps rising.
Notwithstanding the afore-mentioned short-term risks, we see a very supportive environment for developed markets. Consumption and capital spending are alive and well and there are clear signs that we are moving from the recovery to expansion phase of the cycle and leading indicators continue to improve or stabilise from a high level.
Monetary policies in developed market countries are still stimulative. The European Central Bank and the Bank of England are likely to keep rate hikes well contained while the US Federal Reserve and Bank of Japan appear to be in no hurry to raise rates at all.
The corporate situation also continues to look strong and valuations on most risky assets – equities in particular (relative to interest rates) look attractive.
Compared with developed markets, valuations in emerging markets are no longer so attractive – economic growth is likely to weaken as monetary policies are tightened to avoid overheating.
Conversely, the above factors that are good for developed equity markets are not so good for bonds (low interest rates, the removal of excess liquidity in the US and normalisation of monetary policies). We therefore remain positive on equities over the medium term, negative on bonds and favour developed markets (US and eurozone) over emerging.
Christophe Belhomme is chief investment officer at FundQuest