Many investors have been actively reducing their equity allocations in the wake of the global financial crisis. Investors had been heavily reliant on equity returns in the past, but with maturing pension plans, the market volatility of the past decade has been more than some investors can bear. Evidence suggests that the assets that left equity mutual funds in the wake of the financial crisis continue to rest in “safer” assets.
It may surprise you to know that since the financial crisis, equity markets have performed relatively strongly, despite continued economic uncertainty and market volatility. For the four years ending November 30, 2012, equity markets in Canada and the United States have delivered returns of more than 10% and 8% respectively, emerging markets almost 14%, and even poor Europe 4% (annualized, in Canadian dollars).
Performance has been strong despite the mediocre global economic recovery. Monetary easing, supportive business conditions including weak wage growth and low financing costs, robust corporate balance sheets, and increasing institutional investor risk appetite (from very bearish levels) have all combined to drive equity markets higher. Investors’ appetite for “riskier” assets has not been limited to equities. Corporate credit has also delivered strong returns over the past four years, in excess of 10%. Corporate credit has also benefited from many of the same influences as equities, with corporate spreads narrowing in response.
Not surprisingly, at this time of year, we start to think about the coming year and what it might mean for investors. Over the next year or so, the outlook is one of moderate global growth, with growth accelerating over the coming years.
Several key economies appear to be responding to monetary easing initiatives undertaken this fall.
Chinese data over the last month or so has picked-up, while the U.S. is returning towards a moderate growth path (assuming they avoid the fiscal cliff). The Canadian economy is expected to pick up into 2013 as U.S. growth improves and demand for our commodity exports increases.
Global growth rates have responded to these initiatives, and are modestly improving despite European growth, which remains stagnant.
From 2014 onwards, we could start to see U.S. household demand growth accelerate, as the mortgage debt overhang unwinds. In combination with trend growth from China of around 8%, prospects for corporate earnings may well be better than equity markets are pricing-in.
On average, developed world equities continue to reflect an outcome of relatively weak real earnings growth and economic activity over the medium to long term.
Our forecasts are for more positive economic and earnings conditions, indicating equities are reasonably attractively valued over the medium term. This is especially so when compared against the prospects for government bond yields, which remain at unsustainably low levels. While corporate profit margins have been relatively high over the past few years, conditions remain supportive for continued cost control – labour market slack, excess capacity and low interest rates.
The relative attractiveness of equity valuations still needs to be set against the economic and event risks that are still prevalent. The U.S. seems to be making progress in avoiding the “fiscal cliff” with concessions being made by both political parties. The result of not achieving agreement could be to reduce U.S. GDP by 1.0% to 1.5%, which of course, would have a direct impact on the prospect for growth for other countries and would impact corporate profits.
Europe also remains a potential source of market volatility. The deleveraging continues throughout Continental Europe, and we expect this to lead to sub-par growth over the next few years.
In order to avoid a depression, rescue funds for impacted economies are needed (in combination with spending cuts) which in turn requires continued support from the stronger Eurozone countries, notably Germany. Equity market returns have already discounted this repressed environment, but not one of Euro breakup or the default of larger countries such as Spain or Italy, which would undoubtedly lead to negative equity market returns globally.
So, perhaps it is time to take another look at equities, at least in the near term.
For investors who are on a path of de-risking, this might mean pausing for a while.
For those investors who are interested in being more dynamic in their asset allocation, it would seem maintaining or increasing investment risk could deliver potential benefits.