Buttonwood
Hope springs eternal
Investors are optimistic but 2013 is unlikely to be a bumper year
Jan 5th 2013
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MARKETS are beginning the new year on an upbeat note. The immediate cause for celebration is the deal reached in America this week not to plunge over the fiscal cliff, although legislators have merely bought themselves another couple of months. More late-night negotiations will follow in February and March.
But even before the deal was struck, fund managers polled in December by Bank of America Merrill Lynch thought that the global economy would strengthen this year and that profits would rise. They were also more optimistic about the Chinese economy than they had ever been in previous surveys. (The latest Chinese purchasing managers’ indices were solid rather than spectacular.)
Canny investors will assume such optimism is already reflected in the price and will be looking out for surprises. At the start of last year few investors anticipated that shares in banks, or the government bonds of Greece and Portugal, would be among the best-performing assets of 2012.
When assessing the year ahead, most investment strategists start with the economic outlook. But that is often a mistake, as 2012 demonstrated. It was not a great year for growth in the developed world, nor indeed for profits, but stockmarkets still generated healthy returns.
The rally was largely the result of two factors. First, pessimism about the prospects of a euro-zone break-up was lifted by the willingness of the European Central Bank to buy the bonds of troubled nations. With his pledge to do “whatever it takes” to save the euro, Mario Draghi became the pin-up boy of the equity bulls.
Second, many equity markets started the year looking reasonably cheap, particularly in comparison with government bonds. Investors were attracted to corporate bonds and to shares with a decent dividend yield, since the income available from government bonds and cash had dwindled to historically low levels.
The consensus view is that investors will still be tempted to buy equities in 2013. Cash continues to provide a return of close to zero in most developed markets and there is no sign of an increase in interest rates. Government bonds in the “safe” markets of America and Germany offer dismal returns by historic standards.
A couple of caveats are needed, however. The first is the path followed by Japan after its bubble burst in the early 1990s. Government-bond yields fell to low levels and stayed there. Equities managed the occasional sharp rally and then slumped again; the Tokyo stockmarket is still trading at only a quarter of its end-1989 level. Perhaps the rest of the developed world is following the same script.
Furthermore, European and American investors may be tempted to hold on to their government bonds in the belief that central banks will not allow yields to rise significantly. Just as there was perceived to be a “Greenspan put” in the equity markets in the 1990s (ie, the Federal Reserve would always intervene if shares slumped), there may now be a “Bernanke put” in government bonds.
The second caveat is that the stockmarket gains in 2012 were largely driven by a revaluation of equities. “We know of no major asset class that is cheaper now than a year ago, and many are significantly more expensive,” says the strategy team at Morgan Stanley. On the most reliable measure, which averages profits over ten years, American shares trade on a cyclically adjusted price-earnings ratio of 21, well above the historic average, according to Robert Shiller of Yale University.
Profits may move higher this year. Analysts forecast an increase of 11% for the world as a whole. But analysts are always optimistic in January, only to revise down their expectations later in the year.
The greatest scope for profit increases may be in Europe, where margins are at a 20-year average. In American and Japan, in contrast, profits look high relative to GDP. Another bullish argument for European shares, made by strategists at Société Générale, is that they are trading at around their lowest valuation, relative to American equities, in the past 30 years.
Cautious optimism is probably the right attitude. Central banks may be keeping their feet to the monetary accelerator but the brakes are being applied in the form of fiscal policy. Even if the developed world is not stuck in a Japanese-style rut, a revival of global growth could bring renewed problems in the form of higher commodity prices. Although investors are not as complacent as they were heading into 2000 or 2007, say, it is still hard to believe this will be a bumper year for returns.
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