Equity weather forecast. Prolonged sunshine
Equity markets remained strong and the portfolio continued to outperform well, with a monthly gain of 3.2% vs 0.6% for the index. After two decades of policy torpor, Japan’s government has rapidly adopted a trio of policies to kick start the economy: monetary and fiscal stimulus, plus a weak yen. This is ‘shock and awe’ relative to GDP, being far greater than any experiment in any developed country since the Second World War. America’s seemingly gigantic QE experiments now seem puny in comparison: assets at the Federal Reserve Bank have risen above the once unthinkable 20%; Japan’s target is three times greater at 60%. Whilst these changes are unprecedented in their speed and size, they confirm that all leading central banks believe there are no alternatives, so will continue to repeat and rotate each others’ strategies. These strategies mean the use of fiscal and monetary policy to stimulate economic growth, to strengthen their banking systems, reduce budget deficits and deflate the giant debt bubbles arising both from years of financial ill-discipline and theimpact of the 2008 global banking crisis.
There is very little evidence that such policies actually work; even their supporters in the US, Britain and Europe admit that any impact has been marginal so far. Yet governments and central banks are convinced that this enormous and unique experiment by academic economists is a sure panacea, and that if given enough time, it will work. Given their track records, scepticism is justified. Investors however can rely on governments to provide long term support for equity prices. Because if or when the desired results do not happen, then out of stubbornness or perversity, policy makers will engineer even larger stimulus packages to provide further time for success. As has been the case over the last four years, there is one area which really does benefit significantly from these policies: equities. There is no reason why this cannot continue for a prolonged time.
There are threats to such an optimistic forecast. One is creeping austerity. Between 2013 and 2016 America’s sequester programme knocks over a trillion dollars off government expenditure, whilst the end-2012 fiscal cliff has already removed tax breaks and reduced earnings through higher payroll taxes. At the State level, weakening employment and government expenditure cuts have already started. The EU’s sovereign default and bank crises have not been resolved. The Iberian and Greek economies are shrinking, so budget deficits are soaring. Further bail outs will be required. France’s economy is proving to be incapable of reform. A recession has already commenced.
The Italian elections have made the impossible possible. The record anti-establishment protest vote propelled a new pro-spending party to second place, headed by a politician who was once a professional clown. Yet political horse-trading has resulted in Europe’s leading buffoon - Mr. Berlusconi - again pulling the strings, even though his coalition group came third.
Italy also ranks third globally in the size of its sovereign bond market. The economy has not grown this century (even the financial boom years saw no annual change). Another election this year is likely to produce only an anti-austerity/EU undercurrent yet no real government. This will make its borrowing requirements unfundable, which in any case Germany, with its own Federal elections this autumn, will be loath to subsidise. Nevertheless, an Italian crisis is not expected by markets - how else to explain mis-priced 10-year government bonds yielding 3.9%?
Regulators pose further risks, as they fret about the inherent dangers of over-large banks (which through their own policies they have made even more dominant). Their proposals consist of ever-higher capital and reserves; the certain near term result can only be that banks reduce their loan books, a continuation of the last three years.
Hence the golden outlook for equities could be knocked sideways by austerity, sovereign bond implosions, higher interest rates or bank regulations. Some will happen, eventually. However, the base case must be that central banks and politicians will not change the fiscal, monetary and devaluation policies to which they have so recently become eager converts. Nor will they change their almost spiritual certainty that these will work provided they are applied in size for long enough. So when markets wobble on debt or deflation fears, they will be rescued by further money printing. Thus concern that quantitative easing will be slowly withdrawn as early as end 2013 is misplaced.
An unexpected stock market result of these policies is that emerging market indices are likely to continue under performingthose of advanced nations, especially the US and Japan. In America, earnings growth and expectations are well ahead of developing countries, and valuations lower. Japan’s radical new policies seriously threaten emerging equity market returns, especially in Asia. In particular, a weaker yen improves Japan’s export competitiveness against the more industrialised countries of Korea and Taiwan. Japanese investors are repatriating funds from overseas (contrary to most expectations). Moreover, Asian index valuations are high, Japan’s notoriously low. Yet the most important issue may be the effect on international investors. When Japanese markets were soaring in the 1980s, other Asian economies grew even faster but their equity markets were sidelined and valuations stayed low. For, rather than hunt out value in these smaller countries, internationally investors went for the largest and most liquid across the board and stellar returns. In short, low valuations, momentum and changes in fund flows into Japan - which until recently were at record highs into emerging markets - may result in their being relatively sidelined.
© Bedlam Asset Management
