Despite a sluggish start to 2015 global equities quickly gathered momentum and have continued their upward trend. This follows double digit returns amassed in the three previous years, giving an annualised three-year return of 13.5%. Looking back in history, however, three consecutive positive years of equity returns is actually a relatively modest feat, with five consecutive years between 2003 and 2007 and nine years between 1991 and 1999.
Despite bond yields being below equities's, investors favour “safe” yields
This outcome wasn’t completely unexpected given a number of supporting factors. First, central banks almost everywhere in the world have continued with highly accommodative monetary policies and this has driven up the prices of riskier assets. In addition, the actions undertaken by policymakers appear to have considerably reduced the potential for tail-risk events – something that had caused much volatility in the market in preceding years.
Moreover, there was an expectation that investors’ close affinity with fixed income instruments would end, given the prospects of negative returns, thereby resulting in a rotation into equities. Although equities have seen substantial flows over the last year, with equity funds and ETFs available for sale in Europe seeing nearly £44.3 billion in inflows, this is dwarfed by the £111.9 billion influx into fixed income.
The expectation therefore has yet to materialise. Despite bond yields being at record lows and below equity dividend yields in all the major countries, investors continue to favour those “safe” yields. Whether negative yields are “safe” is questionable.
The strong gains seen so far this year were strongly supported by European stocks as well as Japanese equities. Both markets were boosted by expected benefits from weaker currencies against the dollar. US stocks also continued to show considerable strength, with the S&P 500 rising, leaving UK and emerging market equities closely behind.
European Equities Bounce Following Dull 2014
Fortunes have turned for European equities this year following a dull 2014. Corporate earnings disappointed earlier expectations as, for the most part, there has been little by way of earnings growth over the last three years. This was exacerbated by the only modestly accelerating economic growth and the ongoing conflict in Ukraine and the Greek bail-out impasse.
Having said that, there appear to be some positives for economic growth this year as some former headwinds have become tailwinds: the weakness of the euro, the sharp fall in the oil price, and the reduction in the Eurozone structural budget deficit, to name but a few.
The story for the UK, however, is somewhat different. Although economic and interest rate trends should remain supportive for equities, politics remains a key risk, given that the General Election outcome is highly uncertain. Indeed, this has become apparent from our recent conversations with global equity fund managers where the allocation to UK equities has been reduced. It is not only the political risk though; commodity exposure in the FTSE All Share index is higher than its European counterpart, giving it a greater share of earnings downgrades.
That said, the average fund in each of Morningstar’s four global equity categories has so far remained overweight in UK equities.
Fund Managers Up Japanese Weighting
Whilst Japan also disappointed last year, the economy has started to recover and this is expected to continue with further policy support from the government and the Bank of Japan, the depreciation of the yen, early signs of wage increases and the oil price decline. It is interesting to note that despite the yen depreciation, the strong gains seen in Japanese equities this year were led by domestic stocks and not exporters, namely financials and IT.
Overall, commentators expect a year of decent EPS growth and, with valuations relatively low, substantial upside for the TOPIX should growth and earnings accelerate as projected. Global equity fund managers have on average moved up their allocations to Japanese equities over the last two years, though only modestly as the typical fund in Morningstar’s global categories remains underweight Japan.
What About the US?
While US equities continued to show some strength this year, there are some widely shared concerns in the market around the limited potential for continued multiple expansion. With near-term earnings growth being under pressure, this makes it difficult for the S&P 500 index to advance further. The forward price to earnings (PE) ratio for US equities appears to be fully valued and the median and cyclically adjusted PEs have also soared to very high levels.
The Fed is poised to start normalising interest rates. However, in past cycles rate hikes haven’t always stopped equities going up because earnings momentum could offset the contraction in PE multiples. Therefore, the economic cycle and equity bull market still have further to run.
The emerging-markets story remains mixed and is viewed as a difficult call given the wide diversity of issues and problems that the major countries are facing. China, for example, stands at 22% of the MSCI EM Index and emerging Asian countries in total make up nearly two thirds of the index. On the one hand, a large number of countries in Asia are key beneficiaries of lower commodity prices. On the other hand, these lower prices are a negative for Latin America and EMEA, given the relative sizes of Brazil and Russia in their respective regional indices. However, much of this may have already been discounted given the scale of equity falls in those two markets.
As the world currently stands, long-term structural issues in different regions have yet to be solved and as a result we continue to face sluggish and bumpy growth. In such an environment, stock selection remains crucial and many equity managers continue to favour an allocation to companies with strong fundamentals that are able to sustain their growth and have the ability to revolutionise their businesses.
This article originally appeared in International Adviser magazine
