Dan Morris contemplates whether it could be a positive year ahead for investment markets

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 announcement 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 July 2011 levels. 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 year to date. 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 probably 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 fixed income as investors look for alternatives to investment grade debt for income.

Fixed 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 almost certainly incur a loss once yields inevitably reset; the question is when. 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 level returns last year. The decline in yields has now been so dramatic that one begins to question 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 are below 4.5 per cent, levels not seen in two years in Italy’s case. While Spain 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 homeowners 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.

Equities
Returns in 2012 were pretty similar between emerging markets and developed market equities, but in the most recent quarter emerging markets have done better. That highlights one of the themes for 2013: last year was all risk on/risk off so there was little differentiation between countries. We are now likely to be moving ‘beyond risk on’ and there will be greater variation between countries/sectors/companies. That means fundamentals will matter more, though total returns for global equities will still likely be in the high single digits.

We look to emerging markets to continue their outperformance as they have better earnings growth potential and a waning eurozone crisis should remove one of the most significant drags on the market. The recovery that began in China in the first quarter of 2012 should continue, though growth rates will not reach double-digit levels as in the past. This growth will benefit China-dependent markets such as commodities, but also consumer sectors, as the government increases its efforts to reorient the economy away from investment and towards household consumption. More broadly, we generally prefer large emerging markets with dynamic domestic economies that will drive consumer demand, countries such as Turkey, Brazil, India, China, etc, as opposed to traditional, trade-dependent economies.

The US should outperform Europe even though it underperformed in 2012. Europe has benefited from a relief rally as the eurozone improves but now reality sets in and the outlook is not rosy. Corporate earnings are weak and valuations are not much better than in the US. The US will be boosted by QE liquidity, which is lacking in Europe. With margins already fairly high, 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. 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. 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, 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 this year as they are the sector most sensitive to a fall in risk aversion, but next year looks more challenging as business models are questioned and the regulatory burden continues to rise.

Conclusion
The world is obviously not without risks, however. 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 the inevitable 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

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