As the year draws to its close, we are no nearer to a sense of security about where the markets are heading. Clarity and conviction continue to evade many. A key question making the rounds is: “what should I be watching?”
And even more crucially: “what is priced in to the markets?” What is worth remembering is no matter the global environment, opportunities remain to be discovered.
The disconnect between the actual severity of financial issues and the perceived level may have frustrated fund managers focused on fundamentals but it is a phenomena to be exploited. Deeper insights into the macro environment as well as the portfolio positioning of investors can give guidelines when asset allocating. Bottom line: exploit the opportunities but be wary of beta, unrealised correlations and position yourself with protection from future pullbacks.
Starting with the global macro-economic environment, are we seeing the conditions for a sustainable, strong recovery and is it time to be adding risk aggressively? We’re not there yet. The three stages to look for are lending, spending and job-creating. Throughout the world we may have seen record stimulus programs but crucially, the banks still aren’t lending. Commercial and industrial loans in the US have seen their steepest decline and in the Euro-zone M3 (the widest measure of money supply) growth remains near a record low. With restrained access to credit and for example, in the UK, approximately 750,000 public sector jobs are at risk during the planned fiscal tightening – the consumer is not yet motivated to spend. The importance of this should not be underestimated. In the US, the largest single country contributor to global GDP, 60% to 70%, is driven by the consumer. In addition, it has been argued a mere quarter of the baby-boom generation, which in turn account for a majority of consumption, are under-prepared for retirement.
Thus highlighting the sharpness of this swing from spending to saving. Finally, with respect to unemployment, it remains at a two decade high in the US and a structural issue within the EU. With concerns over spending and end-demand companies aren’t in a hurry to expand their workforce.
The job-creating and self-sustaining phase of recovery has yet to occur. However, there is hope. Pessimism is there to be exploited. As Sir John Templeton maintained: “Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.” And so despite equity valuations at unconvincing levels, the ‘risk premium’ offered to clients for taking on market risk and investing is high. Another point in favour of investing
in equities is a relative one, yield. Cash is offering investors next to nothing in returns, investment grade bond spreads have narrowed substantially and it can argued high yield credit has recovered much more from the crisis than equities. There is a lot of cash on the sidelines and inflows into the market could provide support.
Opportunities remain for astute stock-pickers. If we look at what has driven the market rally we can see in many cases it has been the low quality, high beta Consumer Discretionary names (in the US the S&P500 Consumer Discretionary Index is up over 110% since March 2009 low to beginning of November 2010, outperforming the broader S&P Index by almost 50%) – the companies most likely to be the most affected by an economic downturn, leaving other perhaps stronger names still underperforming the broader markets. This is not a call for sector-specific investing, but instead highlights stock-specific opportunities. High quality companies, with strong balance sheets and cash flow rich are unlikely to struggle or need to raise capital. Instead they are well-positioned to pick up assets cheap and/or increase market share and are a better long-term bet and with some recent underperformance able to be exploited.
This is a time for active management and differentiation. From an absolute perspective you are being paid to take risk and from a relative perspective the asset class is looking attractive against alternatives and finally from a name-specific perspective it is possible
to buy positions in high-quality companies which have upside potential versus their index. With the global economy still looking shaky and the possibility for future data point shocks, managers able to hedge out some of the beta and instead focus on generating alpha and locking-in profits could be more prudent investments. The opportunities are there, good luck in sensibly exploiting them.
