2013 outlook: A post-crisis year?
Written by Dan Morris
Dan Morris finds positive signs across the investment sphere for the upcoming year
Could 2013 be the first post-crisis year for markets? That is, a year when the risk of a eurozone breakup fades, even as the recovery and rebuilding of Europe and the US continue for much longer? Some signs are very encouraging. Yields on peripheral market debt have fallen sharply following September’s announce-ment of the Outright Monetary Transactions (OMT) programme by ECB president Mario Draghi. After numerous extreme spikes over the last couple of years, the S&P 500 volatility index (VIX) is now below its long-term average. Credit default swaps on European banks have declined to the previous lows of April 2011. The latest (though not last) Greek aid tranche has finally been disbursed.
The risk of a chaotic breakup of the eurozone has clearly receded, and not only because of more forceful intervention by eurozone leaders (however tardy). The economic imbalances that precipitated the crisis are also correcting. Italy and Spain are running positive trade balances with the eurozone. Greece’s primary budget (before making interest payments) is in surplus. A more benign environment in Europe will be supported by ongoing liquidity from the US Federal Reserve. The current round of quantitative easing (QE) will see the Fed purchase $85 billion of mortgage-backed and Treasury securities through 2013 and perhaps into 2014. This liquidity will provide support for risk assets generally, but in particular equities (both in the US and emerging markets) and higher yielding (and ever riskier) fixed income as investors look for alternatives to investment grade debt for income.
The (partial) resolution of the US fiscal cliff and waning eurozone anxiety should lead to higher yields on safe haven assets, though continued loose monetary policy and low economic growth prospects will limit the rises. The ever more desperate search for yield will continue as the income generated by ‘yield havens’ — riskier assets such as high yield and emerging market debt — plumb new depths. For example, US high yield debt is offering a yield-to-worst of under 6 per cent compared to an average of over 10 per cent since 1986. Purchases today of these assets will incur a price decline once yields inevitably reset (the question is when), though the comparatively high yields provide a cushion. One alternative may be leveraged loans, which offer commensurate returns even as they provide more security.
There is still scope for spreads to compress further for both high yield and US dollar emerging market debt as US Treasury yields rise. Relative to prospective default rates, the extra compensation appears generous. Emerging market US dollar investment grade corporate debt still provides some premium to other investment grade asset classes, and local currency emerging market sovereign debt has not seen the same yield compression as have other fixed income emerging market assets. Fixed income investors may nonetheless simply have to content themselves with meagre returns for the time being.
Peripheral eurozone debt, which was once considered beyond the pale for an even modestly conservative investor, is now becoming respectable again. For the more adventurous, they provided high-yield like returns last year. The decline in yields has at times been so dramatic, however, that one questions whether they offer adequate compensation for what remain substantial risks. Yields on 10-year Spanish government debt are near 5 per cent and for Italy nearing 4 per cent, levels not seen in two years in Italy’s case. While Italy is still likely to end up with a government broadly committed to further fiscal consolidation and market reform after the upcoming elections, there is still plenty of potential for political surprises.
Spain has yet to determine whether it will ask for a bailout via the OMT programme, and there is the ever present risk of a dramatic increase in mortgage delinquencies and defaults if the country’s high unemployment rate forces home-owners to despair of ever paying off their obligations. While peripheral country yields no longer reflect the risk of a eurozone collapse, they may well adequately reflect the risk of over-indebted borrowers.
We look for the US to outperform Europe even though it under-performed in 2012. Europe benefited from a relief rally as eurozone sentiment improved but now reality is setting in and the outlook is not terribly rosy. Corporate earnings are weak and valuations are not superior to those in the US. The US will be boosted by QE liquidity, which is lacking in Europe, and stronger domestic demand. Margins are already fairly high so earnings growth will be a challenge but US corporations are flexible enough to improve upon them.
There are still opportunities within the eurozone, of course. While relative regional valuations are near historical levels, there is a wider range within Europe today than there has been in the past. For example, today there is a gap of 46 percentage points between the cheapest and most expensive market based on forward PEs. Prior to the beginning of the crisis in April 2007, the gap was just 20 percentage points. Two markets we like in particular are Italy as equities are inexpensive, and Germany because earnings growth potential is relatively good and valuations are not stretched even though it performed extremely well last year.
By sector, we expect a continued outperformance of cyclical sectors versus defensives/high dividend yielding stocks, though we do prefer higher yield stocks in Europe. Growth is lowly valued today relative to its own history and relative to high dividend stocks. The overvaluation of high dividend stocks is not necessarily relevant for traditional bond investors who are now looking for income, however, but for equity investors high dividend/defensive stocks are likely to underperform on a total return basis. We like the technology sector (though business hardware and software as opposed to ‘consumer’ technology), consumer discretionary, and industrials. Financials have done very well over the last 12 months as they are the sector most sensitive to a fall in risk aversion, and what appears to be a lightening regulatory burden could help them yet more this year.
The world is obviously not without risks. German Bund yields are still at very low levels, reflecting lingering worries among some investors about the currency union. Upcoming elections in Italy raise doubts about the ability and commitment of a new government to implement budget cuts and economic reform. If Spain were to decide not to ask for a bailout, yields could shoot up again. The US fiscal deficit is still a threat, though it is highly unlikely that any spending cuts will have much immediate impact on the economy as they will be spread out over many years.
Despite these concerns, we believe investors should be moving their assets out of cash and other low yielding assets and into securities offering returns beyond inflation. Equity valuations remain attractive, company earnings continue to grow, and many types of fixed income offer generous yields relative to core sovereign debt.
Written by Dan Morris, global market strategist, J.P. Morgan Asset Management