Uncertain growth prospects at the end of 2011 left many institutional investors taking a defensive position at the start of 2012. But their caution provided fresh fodder for a strong equity rally during the first quarter, when seasonal fund flows helped to whet risk appetites even further. The first quarter has been characterized by an upturn in enthusiasm as a result of December and February provisions of liquidity from the European Central Bank; orderly restructuring of battered bonds in Greece; and a steady diet of favourable economic reports, especially in the U.S.
Alas, the tide turned when China tempered its GDP growth outlook for 2012 on March 5, paring it to 7.5% from 8.1%; cyclical themes and commodities began to stumble; and the greenback gained as investors started looking to the U.S. for economic resilience. Elections in France and Greece brought notable defeats for current leaders, but it was the inability of competing Greek parties to form a coalition government that roiled markets the most. With plans to reject the euro gaining considerable popular traction, banking deposits in the Eurozone periphery grew vulnerable to fraying financial nerves, and sovereign yields in Spain started climbing rapidly again.
But while global economic data have shown signs of deterioration in the last quarter, most central banks stand ready to intervene should the situation worsen. With any luck, this will provide enough reinforcement to a world beset by problematic public debt burdens in a majority of developed countries. Stalled momentum in fixed income should temper flows into bonds and keep investors on the prowl for stock market entry points, since it remains abundantly clear that short-term cash holdings will continue to produce minimal return.
Sentiment tug of war
The evolution of earnings estimates in early 2012 reflects a similarly conservative mindset. After holding up nicely through the challenging second half of 2011, profit expectations for U.S. companies in 2012 have faltered slightly in recent months. In Europe, company analysts pared their earnings outlooks steadily through late 2011, and they have continued to trim their views through the first half of this year. While these trends make equity averages slightly more expensive in valuation terms, they also create a sentiment backdrop that is less prone to disappointment.
Macroeconomic sentiment, on the other hand, offers a less helpful backdrop. The Citigroup Economic Surprise Indices measure the degree to which incoming economic data outpace consensus expectations. In the developed markets, the scale of these beats has eroded from peaks set during the first quarter. In this period of softness, investors are looking for any signs of upbeat activity in economic indicators before getting inspired again. Canada has continued to improve its rank among the G10 countries as per this index. These consistent good numbers may be hard to maintain in the upcoming quarters, however, as signs are mounting that the global recovery is still under siege, thus exposing Canada to some vulnerability. This is especially true in a context where raw material prices remain well contained.
Through the minefield
Tricky global cross-currents may be contributing to the conspicuously mixed signals that different sentiment indicators are emitting. While market activity in the latter months of 2011 succumbed to facile characterizations of broad risk proclivities, January and February 2012 produced sustained prosperity across a wide range of asset classes, and March swiftly reminded investors to raise their guard when less than stellar data began to make the headlines.
Government bonds declined together with many non-U.S. equity markets. Canada didn’t escape and has been impacted hard by the downturn in commodities following China’s lower expected growth. Meanwhile, U.S. shares gained ground at the same time as the U.S. dollar. These discordant behaviours may reflect less uniform global conditions that create fresh opportunities both within and across asset classes, and they help explain why investor sentiment is no easy read.
Spearheading the rallies in 2012 have been financial shares. With capital adequacy tests passed in the U.S. and refinancing operations in place across the eurozone, financial shareholders seem excited at the prospect of better dividends and buybacks. This proved to be short-lived as a desperate shortage of capital in the Spanish banking system was a stark concern for investors. Although financials are surely entitled to a rebound from the rough treatment they received, there’s a worry that difficult asset portfolios and a competitive business environment will remain longer than buoyant liquidity conditions, particularly in Europe.
The S&P/TSX Composite Index defensive sectors such as healthcare and consumer staples have demonstrated particular resilience amid uncertain growth prospects, and it’s likely investors will continue to find the income and stability characteristics of these kinds of equities appealing. Consumer discretionary themes—including autos, retailing and apparel names—have also performed exceptionally well in the first quarter, but they remain vulnerable to a weaker economy and high unemployment.
Energy shares did poorly, losing more than 10% since December 2011 as a result of lower oil prices. The materials sector has been faltering since January, hurt by metals and mining in particular. This lacklustre behaviour suggests that emerging market and infrastructure investment could be playing less of a leadership role during 2012.
One step forward, two steps back
Slower expected global growth and struggling economy, combined with eurozone negative headlines, culminated in a risk-averse environment this past quarter. This has helped put a lid on the Canadian dollar appreciation versus the greenback since the beginning of the year. Although any constructive developments coming out of Europe will be beneficial to risky assets and the loonie, the Canadian economic releases in June were on the soft side, which could potentially curb further appreciation if not reversed quickly.
Up until we see strong signs of economic recovery in the U.S., the loonie will remain somewhat range-bound versus the greenback. Only when a strong recovery finally materializes south of the border will we foresee an underperformance of the Canadian dollar toward the 85-cent level.
Even though Japanese government yields have wallowed in the basement for more than a decade—much longer than the few quarters during which U.S. obligations have sported depressingly low return prospects—many investors seem convinced that money flows into the latter are apt to reverse at any moment. Calls for the end of the 30-year bull market in bonds came quickly after recent selling, but it’s worth remembering that the March spike in U.S. Treasury yields was not dissimilar to their last such move in October, and it looked like a mere blip relative to the yield surges in late 2010. Any unexpected dislocations from Middle Eastern turmoil or Asian deceleration could easily drive yields lower again. And lest we deem European sovereign challenges resolved, Spanish 10-year yields have once again climbed past their Italian counterparts. As for the U.S., the combination of increased taxes and fiscal discipline that without congressional action will arrive at year-end should keep a firm lid on growth expectations.
In order for bond yields to move sustainably higher, there would likely need to be notable momentum in a number of indicators. But wage growth has stayed tepid, and commodities have been quiet. Activity measures have looked a bit better than neutral in the U.S. but a bit worse in Europe and Asia. Whatever one’s own interpretation, these developments have certainly not moved major central bankers to consider increasing interest rates. Implacable in their conviction that overleveraged western economies can heal only by the continued extension and promotion of easy money, these serial accommodators seem oblivious to the investment disincentives and economic distortions fostered by indelibly indulgent policy. Japan is still waiting to see whether such an approach will work. Canadian-U.S. bond yield spreads should remain somewhat anchored. Although Canadian inflation is flirting with the Bank of Canada’s target of 2%, the output gap is still negative. The Organisation for Economic Co-operation and Development expects it to remain as such until the end of 2013, which should help contain inflation pressures in the upcoming quarters.
In the meantime, savers and investors alike must struggle with an artificially suppressed opportunity set. Since long-term return prospects on bonds remain compromised by their insufficient yields, and equity valuations appear constrained by share prices that already reflect historically expansive profit margins, a disciplined focus on income and dividends seems unlikely to go away. Within fixed income, this means that sources of incremental yield, such as corporate bonds, should continue to attract funds. Even though yield spreads narrowed substantially during the first quarter of 2012, and corporate bond yields have risen only slightly from the record lows they set in March, the attraction of higher carry and arguably stronger balance sheets should limit how far spreads can widen in the months ahead.
Tony Beaulac is head of asset allocation (Canada) with SSgA Investment Solutions Group. email@example.com
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