1Q12 was a quarter that defied expectations. Despite simmering
tensions in Europe over its sovereign debt crisis, financial markets built on
the momentum that had begun in November last year to propel risk assets higher.
At the start of the year, we forecast that 2012 would be more
favourable to risk assets and pointed out that valuations were attractive and with
central banks keeping monetary stance accommodative, all that was needed was
for risk premium to recede. We got that bit right except for the timing. We
were initially expecting better times only during the latter part of the year.
But global equities roared back with an 11% gain in USD terms during the first
quarter capping one of its best starts to the year in a decade.
Notably, for the period, most major asset classes – equities,
credits and commodities – appreciated. The exceptions are government bonds and
the USD – the typical bastions of global safe haven. Clearly, this is an
indication of a better risk taking environment. Three major themes have
dominated global markets during this period which resulted in lowering risk
premiums that we had expected.
First and foremost, the critical point in the European sovereign
debt crisis seems to be behind us. The risk of a break-up of the Euro-zone and an
implosion of its banking system have receded dramatically after the actions of
the European Central Bank (ECB) to pump money into the banking system as well
as the successful and orderly restructuring of the Greek government debt. Additionally,
the Euro-zone governments have also agreed on raising their financial firewall
to 700 billion Euros by combining the temporary European Financial Stability
Facility (EFSF) with the new European Stability Mechanism (ESM).
The second big factor was action by the major central banks to
continue to flood the financial system with liquidity. The ECB has effectively
staged a back-door quantitative easing (QE) by lending over 1 trillion Euros to
European financial institutions with two tranches of three-year funding
operations, or LTROs in December and February. Meanwhile, in January, the US
Federal Reserve took a historic step by setting an inflation target of 2% and
at the same time signalled its intent to keep interest rates near zero until
late 2014 and did not rule out a third round of QE. And across the Pacific
Ocean, the Bank of Japan (BOJ) unexpectedly added 10 trillion yen to its
quantitative easing while taking a leaf from the Fed, also announced an
inflation target but at 1%. These actions by the G3 central banks effectively
set a dovish tone to global monetary policy in the foreseeable future.
Third, but not least, is the stronger than expected economic
recovery in the US even though the current pace still pales in comparison with
most other recoveries, including the one following the Great Depression. Both
the manufacturing and services sector indicators have continued to signal
expansion while the housing market has bottomed. More importantly, the
unemployment rate has come off from above 9% since October with more than 1
million jobs created since then. Consequently, consumer confidence has
recovered and consumer spending is on the rise. With this trajectory, the US should
be on track to beat IMF’s projection of a 1.8% GDP growth for 2012.
Over the past few months, we have added incrementally to equities
as our investment framework, which looks at critical drivers such as liquidity,
earnings, valuations, interest rates and technicals, has turned constructive in
January. In particular, the single most important factor in our decision has
been the receding tail risk of an implosion in the Eurozone. This has allowed
for the equity risk premium to fall and for investors to once again focus on
fundamentals. In addition, the leading central banks have committed themselves
to inflation targeting which given the anaemic state of the global economic
recovery means they will continue to hold rates at the current super low levels
and to stand ready to provide further liquidity if and when needed.
So far, so good. Equities have recovered 20% from their October
lows. The S&P 500 index is back at levels last seen before the Lehman
crisis. Can the rally continue?
From a valuation standpoint, there is still significant room for
further re-rating. Over the past decade, equity returns have failed to keep
pace with corporate earnings leading to falling multiples during the period.
The flip side of this de-rating is the rise in the equity risk premium. The
excesses in the corporate world, the banking systems and the deterioration in
the fiscal state of governments in the West have led to greater market
volatility which in turn led to investors demanding a higher risk premium for
holding equities over bonds.
A critical factor to this equity re-rating and a fall in the
equity risk premium is the trajectory of the global economic recovery,
especially in the US and China. A sustainable recovery that is characterised by
virtuous circles where rising incomes and demand reinforce one another will
give markets the impetus to re-rate. And although events in Europe will still
matter, we believe that for the moment policymakers there have effectively
kicked the can down the road.
In late March, Fed Chairman Ben Bernanke mused about the state of
the US labour market and pointed out that improvements in the US labour market
have not exactly been matched by growth in final demand. Friday’s disappointing
US employment report where the economy added just 102,000 jobs compared with an
expectation of over 200,000 seemed to have vindicated his concerns. Investors
are starting to ask if the current momentum will give way to a sluggish second
half repeating the pattern in 2010 and 2011.
That said the labour situation, although critical to a
follow-through in final demand, is not the only driver. Other factors such as
global manufacturing activity, new orders and bank lending have shown signs of improvement
as well. Moreover, it is far too early to surmise that the US labour market has
started to contract with just one dismal job report.
In our view, the likely outcome is continued job gains in the
months ahead but it will be somewhat choppy. We have to constantly remind
ourselves that recoveries following financial crises are typically long drawn
affairs. This one is no different. With the deleveraging still ongoing, it will
be a while before the economy returns to a more sustainable equilibrium level
of employment. Meanwhile, the markets will continue to require validation
through economic data. Consequently and commensurately, the re-rating process
will also be long drawn and choppy.
As for China, markets remain pessimistic as indicated by the
continued underperformance of Chinese stocks, emerging equities and currencies
as well as industrial metals. Investors were spooked by the Chinese government’s
target of 7.5% GDP growth and worried about an economic hard landing. We
believe those concerns are overblown. The lowered target reflects a shift away
from growth at any cost to a desire to seek a more balanced and sustained
economic growth path through rebalancing away from external demand to domestic
consumption. Our view is that policy easing and rising real incomes as well as
the transition to a new political leadership will be supportive of this
rebalancing. But as usual markets will tend to overplay this worry until the
new paradigm is validated.
Fundamentals aside, the tail risks of an oil shock from Iran’s
nuclear intransigence and a financial meltdown in Europe have receded. Oil
prices may be at elevated levels, but a diplomatic resolution could quickly
push premiums down. For Europe, we maintain that it is best to view the debt
crisis as an ongoing one. The process of adjustment, deleveraging and convalescence
will be long drawn and choppy with episodes of backsliding. This may force risk
premium to stay higher than normal but from where we are today, there is still
room for the risk premium to fall.
Therefore, all things considered, we view the recent market consolidation as temporary and probably necessary to move on to the next phase. While we do not expect the next phase to be as strong as the recent months, we retain our constructive portfolio stance to risk assets. Specifically, we continue to be overweight in equities and credits. Our equity exposures are currently concentrated in the US and Asia while we run market neutral strategies in Europe. In fixed-income, we favour selective high yield corporate bonds as well as Emerging Market debt but we stay very defensive with regard to duration. We are also keeping some exposure to gold and alternatives for diversification purposes. Our underweight allocations are on government bonds - nominal and inflation-linked. While we are not ready to call for a bear market in bonds given the accommodative bias of the major central banks, current yield levels are just plain unattractive from a risk-reward perspective.
