Half full or half empty?

We started the year optimistic about equity markets but three months on, it’s hard to know whether we should be pleased or disappointed. Equities have had a sluggish start to the year but, in the light of events, have held up well. The traditionally difficult northern hemisphere spring patch lies ahead but, with so much already discounted, it’s hard to see what could cause it. As always, the market steers a course to make fools out of the maximum number of people.

The first quarter has been marked by a natural disaster in Japan, turmoil in the Middle East, soaring fuel and food prices and the threat of inflation. Bubbling away in the background is the euro-zone crisis, the Chinese property market and the US budget deficit, each threatening to blow into a major crisis. Our collective faith in the ability of governments and central bankers to sort out the mess or avert further problems is about zero; as Reagan once said “government is not the solution to our problem; government is the problem.”

The bears are constantly surprised that equity markets have remained firm in the face of so much apparent bad news with corrections limited to a few percent. What it is easy to forget is that investors were deeply scarred by two of the worst four global bear markets in 110 years taking place in the same decade; this means that equity valuations carry a significant margin of safety which cushions the market against bad news. Only when the decade of negative returns (for developed markets) has been forgotten and greed fully takes over from fear will markets reach levels which are significantly vulnerable to bad news. That may be years away.

The same does not apply to government bonds. Here the puzzle is why 10-year yields remain below 4% in the UK, the US and Germany (and below 1.5% in Japan) when the US is showing no inclination to cut its deficits and nobody has any idea whether Germany stands behind the ECB and EFSF or not. At least the UK is reporting solid progress in cutting its deficit, but markets are grudging. The stability of the government, and with it the whole fiscal strategy, cannot be taken for granted.

The fear among bond investors is that the end of quantitative easing in the US will bring a jump in yields. For us, this is more of a hope as a jump in yields would force action to curb the deficit and help avert the greater fear – that of inflation becoming embedded. Still, we may have to settle for a slow puncture rather than the bursting of a bubble: at least this will enable corporate bonds to continue to grind out modestly positive returns.

Bond markets are being helped by the reluctance of central banks to raise interest rates. These are looking ever closer, with both the Bank of England and the ECB likely to act in the second quarter but the Federal Reserve still appears to have stuck its head in the sand about the scale of recovery and the threat of medium-term inflation. In the UK, the scale of rate increases being discussed seems irrelevant in the context of RPI inflation above 5% while the base rate is just 0.5%. Much more is needed.

It is scarcely surprising that investors are tip-toeing into equities. They may not like the uncertainty but the certainty of negative real returns from cash acts as a powerful incentive to take risk. The pull of a positive outlook is always a better reason to buy than the push of low cash returns but at least the former is present. Fourth quarter earnings were, again and as we expected, significantly better than expectations which led to earnings upgrades for 2011. This, and the recent setback, leaves the prospective multiple below 13, well below our estimate of long term fair value at 16 and also well below the 14.5 current year multiple seen last December. Provisional estimates show earnings estimates for 2012 in the low teens, bringing the global multiple down close to 11, but we reserve judgment for now. After three years of excessive caution, it would not be a surprise if 2012 forecasts turned out to be too optimistic.

Emerging markets have underperformed but that has not even dented the 10 year record. The long term outlook is as good as ever so it is not surprising that they have already recovered nearly half their underperformance. Otherwise, 2011 has seen a continuation of 2010, with growth outperforming value, small outperforming large and momentum outperforming recovery. The varying fortunes of companies within sectors have been a more important driver of returns than the overall sectors. As last year, it has not been a trader’s market.

The most important lesson has been to stay calm in the face of everyday predictions of fresh disaster. Those who are waiting for the downside to disappear before investing are likely to wait in vain: profits are only earned by those prepared to tolerate losses. We believe an avalanche of bad news is holding the market back for now but as soon as this lessens, markets will likely resume their advance. With tentative signs that commodity prices are starting to fall back, that should not be far away.

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