Global equity markets appear caught between uninspiring fundamentals and pragmatic forces. The result is a return close to zero so far this year, despite the strong volatility of the third quarter.
While fundamentals are not bad, per se, overall global growth and consumption remain sluggish. The IMF predicts global growth in 2015 of 3.1%, just shy of their definition of recession while the OECD has predicted 2.9%. Across the west, wages are growing slowly, consumer spending is cautious and US earnings are declining.
That’s not typically positive for equity markets, yet they remain supported for various reasons. Firstly, even with tepid global profit growth, the effective earnings yield remains above the yield offered by government bonds. Secondly, excess global savings, reflected in the current account surpluses of Germany, China and (less so recently) the oil producers, along with surplus cash on corporate balance sheets, are still finding their way into capital markets. Finally, equity investors continue to take comfort from responsive and highly accommodative monetary policies.
Still, the recovery from the August-September lows is now well advanced - the S&P 500 is close to its all-time highs. Investors are unlikely to bid up prices significantly from here without a meaningful improvement in economic growth and corporate profitability. From a longer-term perspective too, it seems unlikely that the explosive returns recorded by global equity and fixed income markets over the last six years can be sustained indefinitely.
Some risk reduction may be prudent in an environment of subdued returns and bouts of volatility. But opportunities remain. For one, differential performance within equity markets appears more pronounced, with sector dispersion in the S&P 500 climbing above its 20-year average for the first time since February. Active equity managers also tend to outperform when sector and security selection matter, for instance from 1998 to 2001 and then from 2007 to 2008, as seen in the chart below.
Greater dispersion reflects trends visible during the third quarter earnings season. Although revenues and profit growth have fallen for the S&P 500 as a whole, profitability performance has become more divergent within the market. Consumer staples, basic materials, industrials, energy and utilities have tended to struggle, whereas healthcare, autos and technology have fared better. Within sectors variation has also increased. Among financials, Main Street has generally done better than Wall Street. So Goldman Sachs and JPMorgan Chase disappointed while Wells Fargo and Citi were more positive. In the consumer universe, restaurants and pure online retailers have performed well. In contrast, Wal-Mart disappointed. Merger activity has also led to more differentiated performance within markets.
From an asset allocation perspective, tactical re-positioning also offers opportunity. Full valuations and slow-but-steady growth suggest range-bound equity markets, oscillating between episodes of excessive optimism and pessimism. Recently, it seems that stronger growth has created fears of policy tightening and limited upside while signs of weaker growth have raised hopes of policy response, thus limiting downside. Skilled investors will need to define such ranges and look to exploit overbought or oversold conditions.
Bonds also appear range-bound. Modest growth, some scope for higher inflation and a gradual tightening of Fed policy suggest gently rising sovereign yields over the coming year. But excess global savings, cash-laden corporate balance sheets and quantitative easing in Japan, Europe and even Sweden are countervailing forces. In credit, high yield offers potentially good returns, though downgrades and even defaults are likely to increase in the energy sector. Quality issuers are therefore likely to remain attractive, particularly on bouts of nervous market-wide selling. Insurance-linked bonds, junior debt of financial issuers, mortgage-backed securities and credit long/short also offer attractive risk-adjusted returns.
In this more modest return environment, diversification matters more than ever. Macro investing, which aims to capture returns across asset classes, can be an important source of differentiated returns. For example, being short the Canadian vs. the US dollar as a proxy for falling oil production and Canadian economic underperformance; long the British pound vs. the euro as additional ECB easing looks likely; and curve flattening in US Treasuries in anticipation of Fed rate normalisation.
In short, ‘sideways markets’ may not excite investors, but the environment offers attractive potential for outperformance. And there will be nowhere to hide anymore - performance will increasingly be a function of investment acumen rather than a rising tide lifting all boats.