Generating positive returns in 2012 through long-only investing was relatively easy.
Hindsight investing, however, obviously does not fully take into account the complexity of decision making at the time, nor the potential outcomes that may have occurred if policymakers had not been so active. So, how repeatable is this for 2013?
January has witnessed a typical ‘pro-risk’ rally. Equity markets delivered positive returns and outperformed fixed income with rising yields taking government bond and credit returns into negative territory. This has been the catalyst for a number of debates, ranging from whether this is this the year of the ‘great rotation’ from fixed interest to equities, will bond yields mean revert, are we coming to an end to the ‘risk on/risk off’ environment, and what is the correlation backdrop we are moving into?
Many of these questions are interrelated, and the answers are not black and white, but they are, nevertheless, important factors to consider.
In spite of recent fund flow data showing a material change in risk appetite by investors, it is far too early to take a view that a material reallocation to equities is underway as it would ignore more structural trends.
We are also sceptical that sovereign bond markets are at the early stages of a mean reversion in valuation, given that this makes a huge assertion regarding what the mean should be, and underestimates the fragile nature of the medium-term backdrop.
The likely correlation environment between equities and bonds is more interesting. Rising sovereign bond yields could pressure equity markets by jeopardising both the relative valuation argument for equities as well as place economic recovery at risk. Our view is that the valuation argument is so strong that yields have room to rise before this creates a problem.
Negative correlations between returns can therefore persist, but only last while bond yields are ‘low’. Assuming yields are driven by growth expectations or risk appetite (rather than sovereign concerns), then negative correlations can persist.
So, is the ‘risk on/risk off’ environment a thing of the past? We strongly doubt it. Our current view is that this year will be characterised by a continuation of ‘risk on/risk off’ environment but ultimately, equity markets will continue to make gains. Given valuation constraints in credit, we are switching it for equity risk as the risk/reward trade off is more attractive there.
However, an end to volatility is too strong a statement as it is important to remember that the medium-term backdrop is still challenging, and the probability of event risk coming back to the market remains.
Low medium-term growth rates in the developed world, fragile economic cycles, and a shortage of policy tools to manage downturns will put a ceiling on market rallies (and price-to-earning multiples) and increase their sensitivity.
