The marked appreciation of most risk assets over the last three months has accompanied strong signs of a shift in the focus among global policy makers away from fighting inflation and towards a seemingly more pro-growth stance.
From Mario Draghi’s commitment to “do whatever it takes” to save the Euro, to new rounds of QE from the Fed and Bank of Japan, to steps in China to increase infrastructure spending, there has been a broad-based acceptance of the need for action to stimulate growth. This has been accompanied by policy easing across the globe over the period, with Brazil, Australia, South Korea, and Sweden amongst others cutting lending rates in recent months.
These moves can in no small part be seen as a reflection on the easing of global inflationary pressures since the beginning of the year, with headline rates dropping sharply (see chart). While concerns remain (such as signs of increasing food prices and on-going property issues in China) markets have largely reacted positively to the greater freedom to tackle growth that disinflationary trends appear to have given policy makers.
From a valuation standpoint, little has changed in spite of this positive performance from risk assets. The gap between many equity markets and mainstream government bond yields remains at historical extremes (see chart), with US, German and UK bonds continuing to offer negative real returns. Such valuation signals suggest favourable odds to backing selected diversified equity markets from here.
An interesting trend in recent price action has been the observation that investors appear to have “climbed the risk ladder” so far this year. As short and intermediate mainstream government bond yields have been driven down by a combination of investor risk aversion and quantitative easing in the West, periods in which risk appetite have returned have been accompanied by investors seeming to turn to “the next safest asset.” Initially this appears to have been longer duration government bonds and investment grade credit, followed by emerging market government bonds, then high yield credit, and is reflected in equity markets by the differential performance of “quality” and dividend paying stocks versus more cyclical companies.
The persistence or otherwise of this trend may have important implications both across and within asset classes in terms of the opportunities that arise in the period ahead.
The economic environment remains mixed, with data in the US continuing to point to a slow, “muddle through” recovery; recent housing data has been encouraging, while manufacturing output data has worsened. Data continues to be weak in Europe, and China has shown further signs of slowdown, reflected in the IMF’s recent downgrade of its growth forecast.
Earnings news has softened of late, though the extent of the recovery from 2008 is still surprisingly strong and valuation signals continue to suggest a meaningful margin of safety in this respect over the medium term.
With the focus on political issues still heightened, potential problems such as the US election and “fiscal cliff,” Spanish and Italian responses to the conditionality of the ECB’s assistance programme and a whole range of possible developments that are not even being considered at present could well drive short-term volatility in the period ahead. Scaling capital appropriately and being in a position to exploit the opportunities that such volatility could create will continue to be important.
However, it remains the case that a buy and hold strategy would have resulted in a positive return from most asset classes so far this year and that is in spite of an environment in which we have seen just such politically-driven volatility. Remaining objective about the facts, and not succumbing to noise will be equally important.