A post-crisis era?

Global equity markets might have rallied at the beginning of 2013, but there is still plenty of uncertainty about the health of the world economy.

Equity markets and risk appetite have come back to life so emphatically in recent months that it’s fair to ask if we are moving into a “post-crisis era”. Is this the true beginning of recovery, not just of our battered economies but also of our investment returns? Can they regain the heights enjoyed before all the trouble started?

The mood in the markets has been lightening ever since the European Central Bank president Mario Draghi (pictured, below right) promised to do “whatever it takes” to save the euro. The ‘Draghi put’, as it became known, was in July 2012. The former Bank of Italy governor raised spirits more dramatically in September, with the announcement of the Outright Monetary Transactions programme. By promising unlimited purchases of the bonds of troubled eurozone issuers like Italy and Spain, he alleviated – though he did not remove – one of the three big weights on investors’ minds.

In addition to the eurozone crisis, investors have been anxious about the US economy, and its fiscal cliff in particular, and about lasting prospects for Chinese growth. It is as these concerns appear to have been addressed, at least temporarily, that the flow of cash into equity markets has grown, reaching flood proportions in January. The Standard & Poor’s 500 had its best January since 1997.

In the first two weeks of this year, net flows into US-based equity funds were $11.3 billion (€8.3 billion) according to Lipper, the biggest fortnightly since April 2000. Add in exchange traded equity funds, and the combined total of over $18 billion was more than twice the flow into bond funds in the same period, a distinct reversal of high-crisis distribution. In the first week of January, cash going into emerging market equities set a new record of $7.4 billion, according to data gathered by EPFR Global. That was five times as much as what went into emerging market bond funds.

In the UK, equity fund sales outstripped fixed income for each of the last four months of 2012, according to the Investment Management Association. IMA chief executive Daniel Godfrey described this as a “clear shift” in investor mindset. Such developments have inspired the theory of The Great Rotation, a term coined by Bank of America Merrill Lynch. This asserts that the past decade’s trend away from equities and into bonds is now going into reverse. As investors switch from low-yielding fixed income back into equities in 2013, equity prices will rise, or so the theory goes. Some are sceptical, arguing that big pension funds and insurers are unlikely to return to any overdependence on equities, but most agree that claims of the ‘death of equity’ have been premature.

Returning European confidence has been reflected in a strengthening euro, as more funds come home from safe haven currencies like the Swiss franc and the US dollar. State Street’s Global Investor Confidence Index rose for a second consecutive month in January, by 5.4 points to reach 86.8. The increase was driven by North American and, to a lesser extent, Asian institutional investors. Though European risk appetite remained high, having hit a substantial peak after September’s OMT news, it actually declined in January. That said, German business confidence rose for the third month in a row.

Adding to the generally upbeat mood, Goldman Sachs has been out and about mobilising the feelgood factor. At January’s World Economic Forum in Davos, chief executive Lloyd Blankfein let it be known that he felt the worst was past. “I think the moment of crisis is over,” he told the BBC. “The worst worrisome problems that everyone talked about last year seem to be off the table.”

That same week, Jim O’Neill (pictured, left), the former chairman of Goldman Sachs Asset Management, was spreading a similar message in an op-ed feature in the London Evening Standard. It was headlined Reasons for the world economy to be cheerful in 2013. China should be getting more respect for the way it was adjusting to more domestic, consumer-driven growth, he argued. And if Japan’s new government managed to shake off low growth and deflation, as it showed unaccustomed signs of doing, “the world’s third-largest economy might have more life in it than many of us have assumed for years”.

On crisis watch in the eurozone, the immediate outlook is relatively benign. One thing that will guarantee peace and quiet in Europe for most of this year is the German general election in the autumn. “The German government doesn’t want any decisions that could have potentially negative consequences on the German economy [before then],” says Alexander Godwin, global head of asset allocation at Citi Private Bank. “So they are not going to push Greece out of the eurozone or bankrupt the Spanish banking system. The political risk is in elections elsewhere, particularly in Italy.”

Economic growth will clearly be poor in Europe this year, with largely negative numbers in GDP and industrial productivity. “The only signs of life are in confidence indicators, which have been picking up,” Godwin says. “But expectations are so low that there is actually some potential for positive surprises.”

Like many others, Citi is overweight on European equities this year, mainly because valuation levels are so depressed. While not as bad as they were a year ago, Europe remains considerably cheaper than the US. Godwin points out that, while both markets have a long-term cyclically adjusted Shiller price earnings multiple of around 15x, the US is currently trading at around 22x while Europe is between 10x and 12x. “We see value in Europe,” he says.

This idea of reversion to the mean, investing in poorly performing assets in the hope that they will return to their long-term trend rates, may prove a popular strategy in 2013. According to a table drawn up by UBS, last year’s highest performing asset class was Italian bonds, which returned 30.5%. The worst was ‘quality investment style’, which returned -0.3%.

Indeed, the rewards for risk-taking were very respectable in 2012, with US equities returning 16% and UK equities 17.1%. Philip Higson, head of global family office Europe at UBS, reckons that most people who complain about their investment returns are simply not taking enough risk.

“Returns are about what risks people are prepared to take,” Higson says. “If you are superdiversified, if you are fully hedged and you want immediate liquidity, don’t expect high returns. But if you are prepared to lock up your money in private equity you can enjoy annual double-digit returns over five years.”

World growth is still slower than we are accustomed to, with US GDP down from 3% or 4% to 2%, Europe at zero and emerging markets decelerating. But low growth need not mean low investment returns, Higson insists. “The world has still got productivity growth and GDP growth,” he says. “Globalisation hasn’t finished. Shale gas has halved US energy prices. The idea that returns have gone forever is not correct.”

Others agree, presumably, because Higson now senses family offices moving back from the sidelines into the risk markets. “A lot of people have wanted protected returns, and have given away a lot of upside so that they know they can sleep,” Higson says. “But now they’re saying they can’t sleep because they are not sufficiently invested. There has been a change in dynamic.”

Nonetheless, there remains a widespread feeling that we are not out of the woods yet. “The developed economies will not reach full recovery and revert to structurally healthy trend growth as long as solvency issues remain unresolved and debt levels are excessive,” says Stephanie Kretz, a member of the investment strategy team for private banking at Lombard Odier. “Unfortunately, we don’t see notable improvements in those areas yet.”

Kretz points out that debt ratios in all big economies are higher than they were a year ago, global credit market debt is at record levels, and eurozone banks are still too large and severely undercapitalised. She acknowledges that 2012 was a good year for equities in particular, but says Lombard Odier is more cautious about 2013. “Valuation levels don’t discount downside risks to the same extent as they did at the beginning of last year,” she says, “and [investor optimism] seems too high, considering the fact that macro-economic and systemic risks are more than ever present.”

Given the extent of the current rally, not to mention the diminishing impact of liquidity injections on risky assets over time, Kretz thinks investors should not expect 2013 equity returns to match those of the previous year.

There is mixed news from the east. More people now believe that China’s present growth rate is unsustainable over the longer term, with another housing bubble in the making, though when and if it will burst is unclear. While Chinese growth slowed to 7.8% last year, some believe that its growing domestic consumption is a reason for Europe to be happy. “If China grows at more than 7%, it’s good news,” says Lorne Baring, managing director of Geneva-based B Capital. “If it grows at 8% it’s really good news. In consumption, China is another US, so this should be a shot in the arm for Europe.”

Japan watchers are hopeful that more aggressive fiscal and monetary policy will reinvigorate both its economy and its stock market. While there have been many false dawns in Japanese equities, Citi’s Godwin notes that it is only in the last year that valuations there have at last become level with or even cheap relative to other markets. “In equities we prefer Europe and Japan to the rest of the world,” he reiterates. “We’re neutral on the US and emerging markets. Both have better growth but, because markets have priced that in, they are at more expensive valuation levels.”

Godwin believes that over the long term global equity returns will be somewhat lower than they have been in the past, averaging 8% against a historical level of slightly more than 9%. “If you take that 8% and break it down for the US and Europe, long-term European returns could be more like 10%, with the US at 5% to 6%, because current valuation levels are so high.”

European returns are being helped out by some decent dividend yields. “You can expect yields of over 4% on Italian stocks, on earnings multiples of around 11 times, so with capital growth you could make 10%,” says Baring.

Yet Baring is at pains to emphasise that in parts of the eurozone the picture is still worsening. “Greece is in a terrible depression, and may have to be forgiven all her debts once [German chancellor Angela] Merkel has been re-elected,” he says. “Spain may require a bailout, though if you looked at the performance of the bond market you’d think not. With yields compressed and the euro roaring up, you might think it’s off to the races – but it’s not.”

We’re in relief territory, not committed recovery territory, Baring says. “We need the absence of political shenanigans in the US and Europe if we are to get real momentum.”

Some would say that it’s up to the markets themselves to make sure that the politicians get us through to recovery proper.

“Ultimately, the economic imperative of keeping growth and the economy going has brought politicians to the right decision,” says Keith Wade, chief economist at Schroders. “However, markets – particularly equities – have played a role in this. Should we now enter a period of financial market complacency, the incentive for politicians to act and the prospect of a favourable outcome will be reduced.” 

The Impossibility of forecasting
Red sky at night – investor’s delight? Another year, another forecast. New Year’s prognostications for the next 12 months in the markets are a fact of life, but they are blown off course by events so often that they can be meaningless. Longer-term forecasts are less susceptible to short-term shocks. And, as UK insurer Standard Life points out, taking the long view can be a source of competitive advantage. It opens the door to illiquid investment opportunities while enabling profit from periods of short-term mispricing.

So, rather boldly, Standard Life has now forecasted 10-year returns for a range of assets in each of the major economies. The asset classes are cash, government bonds, credit (investment grade corporate bonds), equity and property, while the markets are the US, the eurozone, Japan and the UK.

The results, published in the firm’s Global Outlook for Q1 2013, are presented in bands with upper and lower limits. Their thrust is that the long-term investor would do better in the riskier classes of equities and property, and less so in government bonds. The latter, averaged across the four markets, promise a range of returns from -2.75% to 1.25% (they do have an expensive starting point). In equities, the average range of the US, UK and European markets is 0.25% to 9%. Even in Japan, equities are forecast to outperform other assets. For property, the central returns hover around 4.25% in the US and the eurozone, 4% in the UK and 3.25% in Japan.

“A combination of initial valuations and sustainable moderate profits growth would enable equity and real estate markets to deliver a sweet spot of investment returns at some point in the coming decade,” says Andrew Milligan, Standard Life’s head of
global strategy.

Across a diversified portfolio, however, the results are not exactly thrilling. The Economist’s Buttonwood did some sums, assuming real returns in the middle of the Standard Life range. If investors put half their money into equities and divided the rest equally between cash, government bonds, corporate bonds and property, the inflation-adjusted returns would be 2.2% in the US and 3.3% in Europe. Which might not be quite what they were hoping for.

Pictures copyrighted to Reuters