Over the last year, markets have enjoyed stellar performance – since June 2012 there has not been a month with a decline above 1%. The MSCI All Countries World Index returned a robust 25% in US dollars and 30% in sterling, from mid-July last year to the middle of May 2013. The market can justify higher levels in due course, but we believe it has gone far enough for now. The downside risk to the market is modest in our view, especially given escalating inflows to equities in the last six months.
Overall, we believe indices may be lackluster for a while, there are likely to be plenty of opportunities to add value with noteworthy contrarian opportunities opening up for equity investors. Below we look at four key themes where we believe equity investors may find opportunity currently:
1) Japan: Short-term caution warranted
While there may be little movement in overall indices, there is scope for some significant changes in market leadership. The Japanese market enjoyed a particularly strong run, rising by more than 80% since the middle of November. The driving force for this has been top down – the government and Bank of Japan is committed to large scale quantitative easing, which led to the yen dropping from under 80 to the US dollar to over 100. However, Japan's 15% subsequent fall serves as a timely reminder that markets do not rise in a straight line. The faster they rise, the more they correct. Granted, there has been some fundamental support for the rise: valuations were very attractive while earnings forecasts rose substantially and continue to be upgraded. As such, it is tempting to buy into the current setback. But tread carefully. A sustained bull market requires revenue and earnings growth beyond that handed to companies on a plate by a weak currency. More innovation, better returns on capital, higher
dividend pay-out ratios and more investor-friendly behaviour by companies. These should be visible in due course, but we would welcome more evidence.
2) Selective emerging market exposure
Emerging markets have underperformed developed markets by 12% in the year to date and by 26% since October 2010. Emerging countries face a series of headwinds. A strengthening dollar drains liquidity from emerging markets. The beneficiaries of rising commodity prices, such as Russia and South Africa, have struggled as prices reverse, as have the beneficiaries of yen strength, such as Taiwan and South Korea. China is struggling to make the transition to lower growth and lower investment, while the momentum of economic reforms in India has stalled and Brazil suffers from a hangover following unsustainable credit growth. In contrast, the Association of Southeast Asian Nations (ASEAN) markets have done well. Mexico is benefiting from improving security, market-based reform and the US economic recovery while Turkey is defying the regional economic and political gloom. Emerging market companies that have focused on shareholder returns rather than growth for its own sake have performed well. The phase of index underperformance may not be over yet, but we believe the case for selectively adding emerging market exposure is growing.
3) Return to cyclicals
Cyclical sectors, such as resources, technology and industrials underperformed defensives such as utilities, consumer staples and healthcare by 20% between early 2011 and April 2013, but have recently started to recover. In normal cycles, cyclical sectors outperform when the market is rising so the underperformance since mid-2012 is very unusual. But investors, scarred by the market events of recent years, have sought bond-like equities with yields better than government bonds, steady growth and resilience to economic disappointment. As global economic growth picks up, investor caution abates and the compelling value in the cyclical sectors is underpinned by strong trading. Cyclicals may be expected to outperform on a sustained basis. This process kicked off in the last month, but it has much further to go. Note – this does not mean that defensive sectors are over-valued in absolute terms; just that there is more upside potential elsewhere. The healthcare sector combines defensiveness with growth and still looks attractive, but elsewhere outperformance appears to have run its course.
4) Small is beautiful
Market rallies are often led by larger companies with smaller companies following. Smaller and medium-sized companies have not been left behind by the market, but neither have they outperformed. Investors have remained cautious, pushed into defensive sectors by the hunt for yield and wary of individual stock risk and the illiquidity of small and mid-cap companies. However, the long-term case for small and mid-caps is compelling based on sustainably higher growth in revenues and earnings. For example, in the UK the FTSE 100 Index remains around 5% below the peak reached at the end of 1999, while the FTSE 250 Index of mid-cap companies has more than doubled over the same period. As risk aversion diminishes and, perhaps, the major indices consolidate, relative outperformance by smaller and mid-sized companies looks likely to resume in most markets.
Max King is a portfolio manager and strategist for Investec Asset Management's multi-asset team.
