In November of this year, the Financial Times reported a ‘once in a generation moment’ – for the first time in more than 50 years UK pension funds were holding more bonds than equities. It was, for many, another sign of the ‘death of equities’, the most significant asset allocation trend since the 1950s. But seasoned investors will be naturally wary of the phrase ‘everything is different’.
In fact, 2012 turned out to be no bad year for equity markets. Admittedly, much of the surge came in the latter part of the year and the rising tide did not float all boats as the phrase goes i.e. raise all share prices. The FTSE 100 has only managed a lacklustre 3.9 per cent to date, but the average UK smaller companies fund is up 20.1 per cent, and the average UK All Companies fund is up 14.2 per cent.
There were some strong returns from more economically-sensitive parts of the market, such as Europe and emerging markets. Sadly, it was another woeful year for Japan, but it was still in positive territory (admittedly, just 0.3 per cent on average).
Can this feat be repeated in 2013? After all, bonds had a good year in 2012 and many asset allocators are using that as justification not to invest in bonds or at least keep weightings to a minimum. There is also the thorny issue of the economic climate with waning global growth keeping many investors negative on the asset class.
It is undoubtedly the case that developed economies have to pay back their still burgeoning debt, which will create a headwind for years, if not decades. This is a difficult environment for companies and does not promise significant earnings expansion.
But there is also some better economic news. The US housing and employment markets are improving, Europe is stabilising and China looks like it may avoid the widely-predicted ‘hard landing’. This too plays to the preference of many asset allocators for equities. For example, Mark Burgess, chief investment officer at Threadneedle Investments says: “Easing tail risks (tail risk is defined here in
Investopedia) in Europe and China lead us to be more positive on equities than we have been for some time. There will, though, be bumps in the road as stock markets react to the latest policy initiatives and developments.”
Equities also have an important advantage over bonds – valuation. Even after a strong run in 2012, equity valuations look, if not compellingly cheap, then at least not expensive. Richard Buxton, head of UK equities at Schroders says: “Everyone knows and focuses on the bad news – and it’s why equities are good value in absolute and in relative terms. Companies have strong balance sheets, good cash flows and rising dividends with many companies’ shares yielding more than their corporate debt.
“There is lots of talk of the ’lost decade’, the ‘new normal’ where banks and governments are going to continue to deleverage for some years to come. Back in 1999 investors could see no clouds; the outlook now is unremittingly gloomy.” A gloomy atmosphere could actually mean next year is a good time to invest in equities. It means that there is relatively little built into the price of equities. As Buxton says: “Starting valuations – not the economic outlook – are the key to future returns.”
On this point at least, many asset allocators believe that equities should still be preferred over bonds. Dominic Rossi, global chief investment officer, equities, at fund manager Fidelity, sums up the quixotic situation for equity investors.
He says: “While the prospects for earnings growth in most developed equity markets are now more modest, a positive case can be made for a re-rating of equities, yet this is dependent on progress being made against some powerful headwinds. With major government bond yields likely to stay low and below inflation, investors will continue to seek positive real returns in higher-yielding, income-generating assets and dividend-paying equities remain attractive on a total return basis.
There are signs that investors are falling out of love with bonds and moving back into equities. For the last two months, equity funds have out-sold bond funds in the UK, according to the IMA. After years of bonds in the ascendancy, it cannot reasonably be said to be a trend as it stands, but it does indicate some a small shift in perspective on the part of investors.
But where should investors look? Well, Rossi’s views on dividends echo those of many investors who reason that even if there is a re-embracing of equities, people are unlikely to pile wholesale into smaller companies if they have previously has a zero weighting to the asset class. They will dip a toe with high-yielding, safety-first companies. This also plays into the demand for yield, likely to remain a theme in markets as long as interest rates remain depressed. As a result, quality, income-generating shares i.e. reliable dividend payers are widely tipped to do well in 2013.
(Mindful Money reported on calls from UK insurers for UK banks to set out a reliable dividend policy earlier this week).
The other big question in equity markets is how to play any expansion in the Chinese or US economy. Which companies will benefit? Again, the answer appears to be the same. It is true that there may be domestic Chinese companies that benefit from the expansion (and certainly Chinese valuations look compelling after a run of poor performance), but the majority of investors are still placing their bets on global multi-nationals, firms which have the skill and the product range to exploit developing markets, while at the same time benefitting from predictable cash flows from developed markets.
Rossi says: “Quality
will remain a powerful theme and stocks with high returns on invested capital will continue to attract a premium. I think selected healthcare, technology and consumer stocks remain attractive. There are high-quality stocks available with strong franchises which benefit from structural tailwinds, which are also returning cash to shareholders via dividends; Nestlé, Unilever, and Sanofi are all examples of such quality stocks. With these strong multinational companies, investors can be fairly confident that they will get their money back and in the meantime, they receive a higher income than they would from investing in sovereign bonds.”
There are some willing to look further afield to the racier parts of the equity market, areas that had been universally unloved but have seen some momentum in the latter part of 2012. This might include China, which had been hit hard by fears of a hard landing, Japan, which remains the ultimate contrarian play, and even Europe, where fund flows have dried up but where just a small shift in sentiment could provide a significant boost to markets.
Ultimately, the growth outlook may have picked up a little, but investors have a smaller margin for error than they did at the start of 2012. Valuations still compare favourably to bonds.
Equity markets are constantly threatened by big events and investors have to take this into account. The risks include variously that the US will not resolve the political arguments surrounding the fiscal cliff, that the situation either politically or economically in China deteriorates, or that the Eurozone could enter a new phase of the crisis.
And yet, Richard Buxton’s conclusion that we are on the foothills of a new equity bull market, may prove seductive for some.