May asset allocation review
|Asset Allocation Indicator|
The torpor into which markets have recently settled is misleading. On the negative side, investors worry about the euro zone, China, politics and a myriad of macroeconomic concerns. On the positive side, quarterly earnings have been significantly ahead of expectations – underpinning forecasts for earnings growth and valuations – commodity price pressures are easing and investors are cautious. While investors worry about the ‘sell in May’ adage, the net outflows from equity funds in April suggest that they chose to sell early.
This may be setting equity investors up for a pleasant surprise in the rest of the quarter, with the bad news already being priced into markets, leaving plenty of scope for better-than-expected outcomes. The rally in government bonds, we believe, gives holders another opportunity to sell at yield levels which may be justified in the short term by a shortage of risk assets, but are likely, in the future, to be seen as having been anomalously low.
Consequently, we continue to leave the asset allocation and composition of our portfolios unchanged, with an overweight allocation to risk assets and a broad range of thematic tilts. In a financial world dominated by instant news, a focus on live prices and short term gratification, the commodity in shortest supply is patience but we believe it makes sense to ride out the inevitable periods of market lethargy rather than fritter away returns from active trading. We remain confident about the returns available in the rest of the year and in the long term, but are ready to reduce exposure if markets move ahead of the fundamentals. So far, that has not happened and, given the nervousness of investors, looks unlikely to happen.
Markets have remained dull in April: since mid-March, the MSCI All Countries World Index has given back about a fifth of the 22% return generated from late November until mid-March. The oil price has eased back a little but the euro-zone crisis has escalated again, with the euro-zone banks index reaching a new low after a reasonable recovery in December/January. 10-year government bond yields have fallen again, except for the distressed parts of the euro zone, with shorter-dated German yields moving below Japan. Corporate bond spreads have widened, resulting in the bonds underperforming. G7 activity data surprises have edged up just above the neutral point, so economic data is in line with forecasts. The gold price has been flat.
The strategic process remains firmly positive for equities, but a little less so than last month. Economic momentum has weakened a little but is still positive. Valuation remains strong, and has slightly improved from last month. Longer-term market momentum has weakened and is now just above neutral. Although it could fade, we believe that the positive signal recommends an overweight allocation to equities, despite the continuing neutral message from tactical indicators.
Changes to profit forecasts have turned from net downgrades to (marginal) upgrades with the trend firmly positive. First quarter results in the US have, so far, been well ahead of forecasts; companies and analysts are pushing forecasts higher, but data has continued to surprise positively. The collective wisdom of strategists is that analysts are too optimistic, so top-down forecasts are lower than the aggregate of bottom-up ones, but even strategists are having to upgrade forecasts. 54% of estimate changes in the month were upgrades (49% last month) on a 20% fall in the number of estimate changes. Estimates for 2011 growth in global earnings are now 11% lower than in May, and 2012 forecasts, are 3% lower. Analysts’ global earnings expectations in the SG Research data as at April 20 shows growth of 7.6% for 2011 (8% last month), 11.4% for 2012 (11.1% last month) and 13.5% for 2013 (same as last month).The global price-to-earnings (p/e) ratio at that date was 13.6 for 2011 (14 last month), 12.2 for this year (12.6 last month) and 10.8 for 2013 (11.1 last month).
Earnings dynamics improved significantly on both strength and breadth but remain very negative on a rolling three month basis. However, this should turn positive soon on the increasingly safe assumption that the recent improvement does not reverse. The number of estimate changes should jump next month due to the impact of quarter one (Q1) results and will exert a bigger impact on the three month average but the weighting of April is, at present, low. Earnings momentum is very likely to improve to positive in the coming months.
Macroeconomic factors were unchanged at neutral overall. The six month trend of the OECD leading indicator continues to improve slowly; it is now in positive territory, but the score is marginally negative as the long-term average is slightly above zero. The ratio of the Institute of Supply Management (ISM) orders to inventories showed slightly weaker orders and slightly higher inventories but the change is not significant. Forecasts for US GDP have improved slightly, as have global GDP revisions. If surprise indicators remain around neutral, forecasts of global growth will be flat and the scores will remain neutral, although this is clearly a positive environment for companies which are raising revenues and profits at well above levels of economic growth.
Medium-term equity momentum has deteriorated sharply to negative as a result of continuing dull markets. A pick-up in the market would swiftly raise this score. This indicator has been volatile recently, as there has been no sustained up or down trend since 2009. Short-term market momentum has weakened a little, relative to the medium term, but remains mildly positive.
The risk environment has improved further and is firmly positive. Of the five risk indicators, four are in strongly positive territory and one – equity/bond momentum – is modestly positive. Credit spreads, liquidity spreads, and both fast and slow volatility measures have fallen to low levels, helped by the fall in bond volatility. Implied and realised equity volatility have both ticked up, but the gap between the two is unchanged and close to its long-term average. Markets are still driven by a small number of factors and potentially vulnerable to negative news, but vulnerability continues to ease (we measure this over a relatively long timescale so this changes only slowly). Turbulence across markets, evidenced by unusual or unexpected correlation between asset classes, is again positive, as volatility remains relatively low and cross asset correlations are mostly normal.
The contrarian sentiment score remains at neutral. Most indicators, including risk aversion, the put/call ratio, and both investors’ and advisors’ confidence, have retreated in recent weeks, but are still only neutral. The market narrative is one of nervousness and volatility but the actual moves have been modest. The rise in markets has not brought fund in-flows which remain at structurally low levels; there has not been the short-term buying needed to sustain upwards momentum, so the score remains negative. In fact, equity outflows have been the highest for April in 16 years. As Merrill Lynch points out, it is hard to generate big upside in the absence of strong flows into equity funds, and hard to generate big downside if the public is not in the market. Finally, the US market is no longer overextended, having met correction targets, although the divergence from other indices remains a potential concern. Markets need to broaden out if they are to continue the Q1 advance.
The scores are slightly higher than last month, but still only very mildly positive – they have been effectively flat since December. Continued improvement of earnings momentum is likely and if market momentum picks up, the medium term momentum signal will swing back to positive. Next month could therefore, see a jump in the score. Continued market weakness is always possible, but it would take terrible, as opposed to just bad news to make markets sell off. The threats to the oil price appear to be fading, markets have no illusions about the sustainability of the euro zone and a weakening of economic momentum is widely feared, so it would take more than this to make a bear case. With the strategic score positive and the tactical score having more upside than downside potential, we are maintaining our medium overweight allocation to equities and expecting equity markets to rally in the next month. The economic cycle is favourable, valuation is good, earnings momentum is improving, markets have consolidated and investors are cautious. In due course, this could evolve into a long-term bull market in equities, but that would probably require sustained growth, a resolution to the euro-zone crisis, a more visible exit from the aftermath of the credit crisis and sustained fund inflows. With corporate profitability in developed economies already high, the outlook for long-term earnings growth is modest, so a bull market would require higher market ratings, hence the importance of an eventual return to a more stable macroeconomic environment.
The rise in bond yields last month has proved to be a false start to a potential bear leg but we have been sceptical of those forecasting a bond market crash, fears of which have been repeatedly confounded. Widening spreads have improved the likely returns on corporate bonds, high yield and emerging market debt, but duration risk has increased. The euro continues to confound the bears, and the dollar the bulls, while sterling has been firmer than poor economic data would suggest.
The crisis in the euro zone has not been resolved, but the risk of a banking collapse has been much reduced by European Central Bank (ECB) actions and resolve. Banks in peripheral Europe remain dependent on ECB funding, but they have been able to reduce their cross-border exposure to the stressed economies. Banks throughout the euro zone remain desperately short of capital, while raising capital from financial markets is extremely difficult and their balance sheets are poorly provided against bad loans. While the risk of a banking collapse is much reduced, it has not been eliminated, and contagion from banking collapses in Europe would spread around the world, weakening the global economy, corporate profits and credit quality and justifying lower equity valuations.
With the credit super cycle – a phase of expanding government, corporate and personal debt which stretches back over decades – at an end, the developed world faces a long period of slow economic growth which could mean slow growth in corporate earnings. With less liquidity to drive up valuations and long-term risk aversion, p/e ratios are likely to remain lower than their historic average. This is probably fully discounted at current market levels but it reduces the visible upside.
The recovery is very unlikely to evolve into a period of strong growth, but that could still emerge in due course. A pick-up in growth could lead to a surge in commodity prices and so be self-defeating. It would indicate that monetary policy was too loose, that the authorities were behind the curve in raising rates and that QE needed to be reversed, realising losses. Otherwise, the consequence would be rising inflation. This could become a threat later in the cycle, however.
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