Commentary: Winds and Weather
The weather has been unseasonably mild in both London and on the eastern seaboard of the United States which I visited a few weeks ago. Equity markets have basked in benign conditions and have maintained their brisk start to the year, leaving bonds trailing in their wake. The MSCI All Countries World Index (gross, sterling return) was up 1.5% on the week, with the MSCI Emerging Markets Index up 2.8% in sterling, led this week by Brazil (+4.5%), India (+4.6%) and Turkey (+5.9%). Once again one of the strongest sector performances came from banks, up 3.5% in sterling, joined by semiconductors (+3.9%) and Insurance (+3.6%).
For those investors for whom the greatest and most immediate pain is that of missing out on rising markets the first few weeks of the year may have been an unpleasant way to start the year. Financials were down 20% in 2011 and are now up almost 10% in 2012! After a year in which emerging market equities were down nearly 20%, there is clearly significant room for recovery, and the pacy start to the year has seen them rise 8.8%. As an example Indian banks are up around 30% from their lows in December.
There is obviously some short covering at play, but last week the MSCI World Index pushed through its two hundred day moving average, and the pain lies with the legacy positions of last year: underweight equities; underweight Europe; and underweight financials. The key positives which may sustain the positive return to riskier assets further into the first quarter are:
1) The ECB’s LTRO underwrites the liquidity risk for the region’s banks and represents a massive expansion of the ECB’s balance sheet, and may also drive down real bond yields causing the euro to depreciate further. This is likely to buy time for further work on fiscal solutions throughout the eurozone, and currency weakness may mitigate the coming recession;
2) Stronger US data, for the 16th consecutive week according to ISI, providing the prospect of better future consumption and corporate earnings;
3) Inflation abating – the UK reported year on year CPI in December down to 4.2% from 4.8%, and Chinese December CPI declined -0.1%;
4) Brazil and the Philippines cut interest rates as the latest in a series of EM easing, with the prospect of eurozone and Chinese easing to come.
On the other hand those investors who are not looking to chase returns but rather to preserve capital will offset these bullish points as follows:
1) The eurozone continues to tread a fine line. Greece may default before long as talks with its private sector (principally) bank creditors stalled last week. The structural problems of Italy and principally Spain will take a combination of pain and time to resolve. There appears as little willingness as ever for Germany to formally underwrite deficits elsewhere in Europe or to sanction full scale quantitative easing, and the journey to industrial competitiveness in Greece, Ireland, Portugal, Spain and Italy will be Herculean;
2) The US deficit has been out of the global spotlight because of concerns about European deficits and about Chinese growth, but whilst data looks strong it too must face some difficult choices – although US politicians may make more noise than sanction action in an election year. Ron Napier of Napier Investment Advisors has pointed out that the US national accounts show a big rise in the government transfer deficit since 2007 which has masked a real weakness in US household incomes;
3) China has had a bubble in construction activity which has produced a surplus in unproductive space at a time when export activity has slowed, the impact of this unwinding could be felt across the world.