Monthly market commentary

Transcription

1 Contents Monthly market commentary February 2014 Equities 2 Credit 3 Nominal Yields 4 Inflation 5 Real Yields 6 Asset Class Performance Summary 7 Comment 8 Contacts & Disclaimer 9

2 Equities: poor start of the year for equities Figure 1: Equity Market Returns (rebased at 100) 1 Equity Markets Index Percentage Change 31/12/ Week 1 Month 1 Year S&P 500 (TR) % -3.5% 21.5% FTSE All-Share (TR) % -3.1% 10.1% EuroStoxx 50 (TR) % -2.9% 14.8% Topix (TR) % -6.3% 32.3% 1 Total returns in local currency Equity indices Over the first month of 2014 equity markets fell across the board. The major developed market indices ended January with losses of around 3% while the Japanese Topix was down 6.3%. This contrasts with the strong performance in equity markets over the previous year. Investors are focusing on emerging markets and corporate earnings An ongoing trouble in emerging markets is likely to be the main factor behind the dismal performance of equity markets. As a consequence of tapering (reduction of asset purchases) by the Federal Reserve, investors have started to move capital back to the developed world. In the process, inherent flaws in certain emerging economies that were previously ignored came into focus. The most important are current account deficits, dwindling foreign currency reserves, lack of central bank independence and years of unsustainable economic policies. Recent political turmoil in countries like Thailand, Ukraine and Turkey did certainly not help to lift investors confidence. The sell-off across the board looks like a slight overreaction as emerging markets are fundamentally different. While countries like Argentina, Venezuela, India, Indonesia and South Africa might have questionable fundamentals, Mexico, Malaysia and the Philippines are in a much sounder position. January also saw the start of the US earning season with mixed results. Hitherto, 70% of companies beat analysts earnings estimates although these had been revised down by almost 3.5%. US stocks have priced in robust earnings growth and thus markets can only advance further if earnings meet the high expectations. After years of cost-cutting, an improving economy which boosts companies revenues should also lead to significant bottom-line growth as the higher multiples are likely to be sustained. However, increasing doubts about the sustainability of the predicted earnings growth could lead to further market corrections over the year. While Financials, Industrials and Technology sector earnings have exceeded expectations by a large margin, Retail earnings were quite disappointing. Given that the United States economy is mainly driven by consumer spending, this development could have worried quite a few investors. Thus, a further rally in equity markets seems increasingly hard to justify and will depend much more on earnings figures than the mere news of an economic recovery in general terms. Page 2 of 9

3 Credit: corporate bond spreads fall over the month Figure 2: GBP Corporate Bond Spreads over Gilts by Rating (change over week/month/year) Source: Bloomberg, Bank of America Merrill Lynch, Capita Figure 3: GBP Corporate Bond Spreads over Gilts by Rating (Historic) Credit Corporate bond spreads fell across all investment grade ratings over January, except for A where they stagnated. Fixed Interest: the other side of the coin In times when investors change their perception of market risk, equities and fixed income often show a negative correlation.amid emerging markets turmoil and mixed signals from the US earnings season, investors seem to have become a bit more risk averse, at least for the time being. As a consequence, demand for risky assets such as equities fell, while safe haven assets such as gold (+3.63% over the month), treasuries and Gilts increased in value. For the latter, 10 -year yields fell by 30 basis points during January. As yields have an inverse relationship with prices, this indicates that demand for government securities has increased. Also, investors might have rotated their holdings from equities to corporate bonds. The latter offers a higher yield than government bond but is less risky than equities. Lower corporate bond spreads over the month are likely to be the result of corporate bond yields falling by a higher proportion than government bond yields. It might seem odd that amid tapering of asset purchases, government bonds are rallying again. If the Federal Reserve, as the largest institutional buyer of Treasury- securities reduces demand, one would expect prices of these securities to fall like they did in However, investors seem to be buying such securities as safe havens in a volatile environment and, therefore, their prices increased and yields fell. If this phase of correction in risk assets is coming towards an end soon, this development might reverse. Markets still expect that Treasury yields will rise later this year and reach a level of 3.25% by June. Source: Bloomberg, Bank of America Merrill Lynch, Capita Page 3 of 9

4 Nominal Yields: Gilt yields lower for all maturities Figure 4: Nominal Term Structure of Gilts Nominal Gilt yields In January, the nominal Gilt curve fell for all maturities. The fall was most pronounced for maturities between 10 and 30 years. Over the year to 31 January 2014, nominal Gilt yields of all maturities decreased, with the largest decrease of 37 bps seen in 15-year Gilts. Is an interest rate rise still a long way off? This month saw inflation fall towards 2%, which is the Bank of England inflation target, while unemployment edged closer to 7%, the forward guidance threshold for a rate increase. At the World Economic Forum in Davos, Mark Carney reiterated that 7% is a threshold and not a trigger for higher short-dated interest rates. Furthermore, forward guidance would be revised in order to provide a more consistent communication to the public. The Bank of England seems unwilling to raise rates yet, contrary to what was announced last June when forward guidance was introduced. Lower inflation should play into its hands as it would not warrant tightening monetary policy yet, despite of the ongoing recovery in the British economy. Therefore it looks like there is still plenty of time before the bank rate rises as the Bank of England seems committed to support the economy as long as possible. Nominal Gilt Rates Maturity Points (yrs) Current % Week Change (bps) Month Change (bps) Year Change (bps) Page 4 of 9

5 Inflation: UK inflation keeps falling Figure 5: Gilt Breakeven Inflation 2 Figure 6: CPI in the UK, US and Eurozone Gilt Breakeven Inflation Maturity Points (yrs) Current % Week Change (bps) Month Change (bps) Year Change (bps) Giltbreak even inflation has been calculated as the difference between nominal Gilt yields and Gilt real yields. Inflation The rate of the consumer prices index (CPI) inflation grew by 2.0% in the year to December 2013 (slightly down from 2.1% in November) according to the Office for National Statistics. This brings the inflation rate in line with the Bank of England 2% target. The largest downwards contributors were food and non-alcoholic beverages as well as recreational goods and services, partly offset by higher fuel costs. Page 5 of 9

6 Real Yields: Real yields fall Figure 7: Gilt Real Yield 3 Term Structure Figure 8: 10-year and 30-year Real Yields Gilt real yields In January, real yields rose fell with greater falls across the short end of the curve. The largest decrease was 19 bps for 10-year maturities. As inflation remained pretty much stagnant at 2%, negative real yields can be mainly attributed to falling nominal yields. Gilt Real Yield Maturity Points (yrs) Current % Week Change (bps) Month Change (bps) Year Change (bps) Amid a small decrease this month, real yields have returned to negative territory at the shorter end of the curve and remained close to zero at the longer end. 3 Gilt real yield has been calculated as the yield on index-linked Gilts Page 6 of 9

7 Asset Class Performance Summary Asset Class Performance Summary The charts below and the table on the right show the one month and one year performance of various asset classes to the end of January Asset Class 1 Month Return 1 Year Return FTSE All-Share TR -3.1% 10.1% S&P 500 TR -3.5% 21.5% Eurostoxx 50 TR -2.9% 14.8% Topix TR -6.3% 32.3% FTSE AW Emerging Market Index TR -6.0% -15.0% FTSEA Gilt +15 Yrs 3.1% 0.6% iboxx Non-Gilt 10+ TR 2.9% 4.5% FTSE A ILG +5 Yrs 1.8% -2.1% IPD Property 2.1% 10.9% 1 Month LIBOR 0.0% 0.5% Page 7 of 9

8 Equities sound fundamentals but very high expectations The fair price of an equity is the present value of its future dividends. If dividends were certain and constant over time, the present value could simply be expressed as a perpetuity (infinitive geometric series) assuming that the company is a going concern that will trade forever, all things equal.for example, a company paying out 0.5 per share in dividends would be worth 10 using a discount rate of 5%. In practice, dividends are neither certain nor constant. Factoring in expected dividend growth makes it a bit more challenging mathematically (although the output of the equation still has the same meaning). However, depending on expected earnings growth, the price paid by share might far exceed the fair value. As equity prices are determined by supply and demand, all available information that filters through to future expectations will be reflected in the equity price. Furthermore, psychology (John Maynard Keynes s famous animal spirits) must be added in the short run, although, in theory, in the long run markets should be efficient and will tend back towards the equilibrium. Therefore, stocks can be too cheap or too expensive for a given period of time. Therefore, the difficult question is whether investors will be able to put their money into the S&P500, lean back and enjoy another year of double digit returns? A 50% funded pension scheme could turn the deficit into a surplus in less than 3 years by simply investing all their assets in the S&P500, assuming it returns 30% over the next three years and making the simplistic assumptions that the present value of liabilities do not change. Investors who believe that, amid the current economic environment, diversification has become obsolete are showing hindsight or recency bias and make the mistake of extrapolating from the past to the future.what speaks in favour of sustained growth is the fact that both the US and UK are actually enjoying economic recoveries, while even the eurozone is making progress. Japan has been boosted by unprecedented quantitative easing that will hopefully reboot its economy. Economic growth leads to more aggregate demand which boosts companies earnings. Thus, expected dividends rise and investors are willing to pay more for equities.the fact that the Federal Reserve is reducing the amount of tapering from this month, without it leading to a strong market reaction suggests that the end of tapering is being taken lightly amid the positive economic environment. However, the S&P500 grew by 30% over 2013 which exceeded the profits growth of its companies (7.7%) by far. As markets are forward looking, future profit growth has probably been priced in.how reasonable is this assumption? Profits/GDP ratio is at the highest level since World War II and as a consequence some analysts revised down their 2014 forecasts in December.Expectations have been set very high. There should be no reason why both the US and UK should not continue their strong expansion into The problem with high expectations is, however, the fact that once expectations have moved too far away from the fundamentals, markets will not take disappointments lightly. Even if macroeconomic and earnings figures still looked reasonable, the realignment of expectations to reality could lead to a correction, if not a bear market. Both in the UK and US, we have seen disappointing earnings figures in the retail sector over Christmas. This month s non-farm roll figures from the US were hugely disappointing. If this does not prove to be a mere blip in the data and we get more disappointing (or only less accelerating figures) markets might show a negative reaction, even if overall data still points towards a recovery. This could be exacerbated as the Federal Reserve s asset purchases are being reduced gradually over the year. As a conclusion, we can see the merit in the growth stories and their positive impact on equity valuations. However, there is a strong possibility that the risk of corrections is higher in 2014 than 2013 as we enter the year with higher expectations. What was a positive surprise last year could be the expected minimum this year. Any setback that would have been taken lightly when expectations were low could become market-moving Page 8 of 9

9 Contacts & Disclaimer Bobby Riddaway Head of Investment Consulting t e bobby.riddaway@capita.co.uk Albert Küller Chief Economist t e albert.kuller@capita.co.uk In preparing this report we have relied upon data supplied by third parties. Although reasonable care has been taken to gauge the reliability of this data, this report therefore carries no guarantee of accuracy or completeness, and Capita Employee Benefits ( Capita ) cannot be held accountable for the misrepresentation of data by third parties involved. The report is for your private information and is for discussion purposes only. This report is based on data/information available to Capita at the date of the report and takes no account of subsequent developments after that date. It may not be modified or provided by the Recipients to any other party without Capita s prior written permission. It may also not be disclosed by the Recipients to any other party without Capita s prior written permission except as may be required by law. In the absence of our express written agreement to the contrary, Capita accepts no responsibility for any consequences arising from any third party relying on this report or the opinions expressed therein. This report is not intended by Capita to form a basis of any decision by a third party to do or omit to do anything. CapitaEmployeeBenefits CapitaEB Employee benefits C005 Capita Employee Benefits is a trading name of Capita Employee Benefits Limited and Capita Employee Benefits (Consulting) Limited. Part of Capita plc. Capita Employee Benefits Limited and Capita Employee Benefits (Consulting) Limited are registered in England & Wales No: and respectively. Registered Office: 17 Rochester Row, Westminster, London, SW1P 1QT. Separately authorised and regulated by the Financial Conduct Authority. Page 9 of 9