13th December 2013
In his latest Investment Theme: Edmund Shing, Global Equity portfolio manager at BCS Asset Management, considers whether retail investors will fuel a further stock market rise.
Clearly, the vast majority of investors in the stock and bond markets will know that this year has been a good year for stocks, but not so good for government bonds. In the US, this difference in performance of these two major asset classes has been dramatic, with the US S&P 500 stock market index beating US government bonds by as much as 30% over this year to date.
In the UK, the performance difference between stocks and bonds is not quite as dramatic, but nevertheless impressive at +21% (see chart below), even after including the contributions from dividends and bond coupons paid out.
Naturally, UK retail investors have not ignored this barnstorming performance from the stock market, and have, as you might expect, been flocking to chase this strong performance by investing in stock unit trusts and exchange-traded funds. According to the fund management industry body The Investment Management Association, retail investors have poured over £9bn into equity unit trusts since the beginning of this year, while net bond fund flows (labelled fixed income funds in the chart below) have been almost zero.
How far could this Equity-Bond rotation go?
Judging from the chart below, still quite some way! Yearly inflows into bond unit trusts beat stock fund inflows each year from 2008 until last year – 2013 is the first year when stock funds have been more popular than bond funds since pre-crisis 2007.
If we widen out our scope and look at the equivalent retail fund flows in Europe as a whole, we see an even more dramatic situation: European retail investors have bought a cumulative EUR344bn of bond funds between 2010 and the end of September this year, while selling EUR259bn of money market (cash deposit) funds over this same period.
We have only seen European investors start to rotate out of bond funds and into equity funds over August and September; given the massive inflows into European bond funds and net outflows from equity funds last year, this could just be the tip of the iceberg. The same is true in the US, where over five years of heavy bond fund buying has only started to be partially unwound this year.
A note of caution: Retail investors tend to follow, not set the market
All of this sounds rather bullish for stock markets, doesn’t it? However, this is but one factor that can drive markets. Note that a number of academic studies have concluded that retail fund flows do not anticipate, but rather follow pre-existing stock market trends.
That said, we can make a number of observations from this wealth of fund flow data:
1. The Wealth Effect is Strong in the US and UK, driven by rising stock prices and house prices. This boost to net household wealth is feeding through into the US and UK domestic economies, notably through retail sales and rising housing-related economic activity.
2. The Equity-Bond switch has started, but is only at an early stage. The more obvious switch has been a “hunt for yield”, with savers opting to buy bond and equity income funds and exiting cash in the form of money market funds.
3. Fundamental drivers combined with fund flows to favour European, Japanese stock markets. US mutual fund investors have notably been big buyers of global ex US equity funds in 2013, particularly focused on Europe and Japan where economic fundamentals are improving and valuations are arguably still cheap, certainly much cheaper than for the US stock market.
4. Continental European investors are late to the party, and remain very cautious. Europe ex UK retail investors are still very cautious despite a 50%+ total return from European stocks since September 2011. 43% of their UCITS fund holdings remain in bond and money market funds, while holding only 36% in equity funds. They clearly remain deeply scarred by the two big bear markets since 2000. Contrast this with the UK, where over 60% of UK funds (unit trusts + OEICs) sit in equity funds.
So what investments can you look at?
While stock markets are currently obsessed with when the US Federal Reserve will begin to “taper” (i.e. slow down) their US government bond purchases, the combination of attractive valuations, improving economic fundamentals and momentum in US and European fund flows point to looking at investing in:
1. European stocks. Within Europe, I continue to prefer to use small-caps as a good way to obtain exposure to improvement in domestic economies. In Europe as a whole, you could do worse than to look at:
(a)The DB X-Trackers MSCI Europe Small-Cap ETF (XXSC), while
(b) The JPMorgan European Smaller Companies investment trust (JESC) is another possibility to consider, currently trading at a 9% discount to its underlying net asset value.
2. Japanese stocks. My preferred choices for gaining exposure to Japanese stocks in a fund format are:
(a) The Baillie Gifford Japan Trust (BGFD), an investment trust that has consistently outperformed the Japanese Nikkei index; and
(b) theiShares MSCI Japan GBP Hedged ETF (IJPH), an ETF which buys exposure to a broad selection of Japanese stocks but which hedges out exposure to the Japanese yen. I like this second option because I believe that current Japanese economic policy, focused on generating growth and inflation in Japan, could be good for stocks but could well lead to further weakening of the Japanese yen against other major currencies.