A calm year ahead for world equity markets

A pendulum has to swing both ways before returning to a centred equilibrium. Does this mean the next few months will see calm world markets? Fidelity’s Betty Ng writes.

World equity markets plunged in 2011 with major indices mostly down, but many across the developed and developing world recovered nicely in 2012, posting double-digit gains. 

This suggests that 2013 can be a year of relative calm, in the sense that total investment returns may be more modest and subdued.

Yet 2013 is not free from event risk, suggesting that income will remain an important total return buffer. A number of investors have already moved into income-producing assets, such as high-dividend stocks and bonds. 

Given the price changes for many securities in the past year, valuations suggest that 2013 may be a year to refine one’s strategy with careful portfolio adjustments. 

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It may seem contradictory to expect modest investment returns despite forecasting ongoing event risks. Yet the large, positive returns in 2012 were partially a rebound from the dramatic corrections in 2011.

After the gyrations of the past two years, markets may well focus more on fundamentals in 2013. 

Since 2008 we have been living in an era in which fundamentals and technical factors have been contingent upon government action and central bank decisions around the world.

The US has just averted the worst fiscal cliff outcome, but realistically the country’s debt ceiling and spending issues have simply been kicked down the road. 

This is a shame because US housing starts have started to improve. In Europe, manufacturing indicators continue to trend down while unemployment is reaching alarming levels, which could threaten social stability and election outcomes. All these wild cards tend to suggest ongoing volatility.  

Tail risk 

Another potential risk down the road is inflation: successive quantitative easing among developed countries has already caused higher prices in other parts of the world.

For now, low-wage growth is keeping a lid on price levels in many developed countries, yet the pressure on prices is quietly building up, and will become more apparent either later this year or early next. 

Markets imply that 10-year US break-even inflation expectations have continued to trend up with each successive round of quantitative easing.

This is why investment income remains an important component to guard against these uncertain developments. The challenge is where to find it and how to sustain it. 

In the past few years, many investors have been turning to bonds for income returns: inflows into bonds have been strong since the global financial crisis in 2008.

In the US, for example, fixed income inflows have been exceeding those for equities since 2006, with pension funds now holding 3 per cent more assets in bonds than stocks. 

Despite the negative headlines about government finances in the developed world, many companies in both emerging markets and the developed world have actually maintained very healthy balance sheets.

The successive rate cuts by major central banks have allowed many of these firms to refinance at lower costs, trimming their interest expenses and enabling them to build up cash positions. 

Strong investor demand based on improving fundamentals has caused US investment grade corporate bond spreads to reach cyclical lows, pushing them below long term fair values.

The same applies to US high yield bonds. New issuance by many firms has also kept high yield default rates at a very low 2 per cent for now. 

Long-term appeal of income 

Some people are now asking whether there is a bond bubble.

A key point to note here is that given the ageing demographics in many countries, there is likely to be sustained and growing structural demand for fixed income securities over the years ahead – regardless of cyclical conditions.

And given the reduced but still present event risks around the world, demand for fixed income instruments will also likely remain solid. 

From a valuation perspective, maybe we can say there is some froth, and as such investors should consider refining and adjusting the types of bonds in their portfolios.

For example, if we take duration – with spreads and rates at very low levels and central banks likely to reflate slower-growth economies – longer duration bonds could be negatively affected. 

Investors may therefore wish to consider shortening duration. In terms of quality, one may wish to consider taking some profits in sovereign bonds and allocating the funds to high grade bonds.

For high yield bonds which have had a relatively good run, a shift to market neutral and to higher quality issuers within this space could provide some safeguard against volatility.  

Emerging markets 

In terms of geography, emerging markets remain interesting from a currency perspective and for those who have a longer investment horizon.

Growth in these countries remains higher than the rest of the world, supportive of their exchange rates.

China’s exports, for example, have rebounded to a seven-month high in December, boding well for manufacturing activities, which traditionally drive currency performance. 

While many doomsayers predicted a hard landing for China last year, the country has come through a slowdown and now appears poised for steadier, higher-quality growth.

The good news on China also bodes well for its key regional and global trading partners. 

Similarly, emerging markets have diversified from doing most of their sovereign issuance in US dollars towards doing more in local currency bonds.

More company debt has also come to the market, while a number of countries have managed to reduce their national debt, improving their fiscal positions and credit fundamentals. 

Currency is a zero sum game. While correlation can increase across asset classes during market turbulence, affecting investment returns across the board, in the realm of currencies there are always winners and losers. With this in mind, maintaining a basket of diversified emerging market bonds could add alpha to total returns.  

Income will also remain an important consideration for many investors in the current investment environment.

Finding and sustaining it will be a challenge however, and investors will likely need to adjust their portfolios continuously and consider adding new elements to enhance returns. 

Betty Ng is director and investment commentator at Fidelity Worldwide Investment.