By Nick Mustoe, CIO, Invesco Perpetual
A profound change in mood has swept through global equity markets since the summer of 2012. Comments in July by European Central Bank (ECB) President Mario Draghi that the ECB would do "whatever it takes to save the euro" boosted markets and forced down Spain and Italy's borrowing costs.
On top of that, the lessening of a number of risks, notably slowing Chinese growth, the European financial crisis and the US fiscal negotiations, continues to support equity markets.
"The ECB will to whatever it takes to preserve the euro."
— Mario Draghi
At a time when many investors were caught too defensive being heavily exposed to bonds, leading equity indices have so far this year reached multi-year highs with expectations of further to go. The VIX index – a measure of investor expectations of volatility commonly known as Wall Street's 'fear gauge' – has also been indicating confidence. In February 2013 it reached a series of new lows not seen since before the start of the financial crisis in 2007.
Financial stability in Eurozone continues to improve
The key question now is: can this re-pricing be justified by the prospects ahead of us in 2013? We need to consider how sustainable the rally can be and whether or not time is ripe for a correction. After all, global equity markets have rallied in anticipation of an economic recovery that has yet to fully materialize. The picture in the developed world has not dramatically changed. We are still in a multi-year process of de-leveraging for governments, banks and individuals, which provides headwinds for growth. Europe still has to undergo a painful transformation as its weaker economies tread a fine line between reducing debt but maintaining employment and growth.
"The key question now is: can this re-pricing be justified by the prospects ahead of us in 2013?"
Yet the outlook for financial stability in the Eurozone continues to improve given the combination of the ECB's OMT program and gradual progress towards fiscal and banking integration. We have also recently seen a number of encouraging steps in terms of labor market reforms. The aim is to boost long-term growth rates, though these measures will take a long time to bear fruit.
Still plenty of scope for bad headlines
France, for example, could be said to be the embodiment of European restructuring and the deal Holland made with the unions (making it more difficult for employers to hire on short-term contracts but easier to fire staff) looks to be successful. Spain's labor market reforms, which seek to limit calls for higher wages and negotiate flexible working conditions, have already made in-roads into the country's car industry. Companies in the car industry and beyond have become increasingly more competitive and have even boosted their exports.
I would caution though that the European experiment is not yet finished. This year I expect there will be plenty of scope for bad headlines and data shocks and we are unlikely to see material earnings growth for European companies.
US housing market has made significant headway
Elsewhere, the US has been one of the few bright spots in the global economy. One particular pocket of strength has been residential real estate. In 2012, the housing market had its first year of recovery since its 2005 peak. Spurred by record-low mortgage rates, home construction made significant headway last year. US housing starts jumped by 28% from the previous year, the biggest annual gain since 1983. The housing market, together with an improved banking sector, the resurgence in US oil production and continued high levels of shale gas drilling, are reasons why the US economy has become a focus for investors.
Prospects for emerging Asia look attractive on an absolute and relative basis
In Japan meanwhile, the new Prime Minister Shinzo Abe has been vocal in his desire to aggressively pursue policies aimed at ending deflation and weakening the currency in a bid to revive the economy. Known as the forgotten market until recently, Abe has already kick-started investor appetite with a big increase in government spending and has laid out his vision of Japan as a reinvigorated Asian power.
In terms of Asia specifically, China is continuing to rebalance away from an investment-led to a more balanced economy. The leading indicators of 2012 suggest that the slowdown in Chinese growth has bottomed out and I believe that the prospects for 2013 look relatively good for emerging Asia in particular versus the developed world.
Equity markets look undervalued versus history and relative to other asset classes
It is increasingly hard to find real value in most bond markets, especially non-financial corporate bonds and core government bonds. I believe that equity market dividend yields look compelling in comparison given the rude health of the corporate sector. In my view, this represents a clear buying opportunity in many high-quality companies which are well financed, with strong balance sheets and good levels of cashflow, and with a proven ability to sustain and grow dividends.