Equities in 2013: boring would be best

For equity investors, the past five years have been anything but boring. In 2008 they got the Great Crisis and in 2009 / 2010 the Great Recovery. So far so good. From mid 2010 onwards the investment environment changed. In a struggling global economy, policy decisions by central banks started to become the main driver of investor sentiment, even more so than corporate earnings. The economic cycle shortened and started to adopt the rhythm of the liquidity injections provided by central banks. Up- and downturns generally lasted no more than around six months. And throughout this period, interest rates kept falling and falling, finally becoming negative in real terms.

As a result, equity markets have become more liquidity driven than earnings driven. This is especially clear when one compares 2011 and 2012. For a large part of 2011, corporate earnings surprised on the upside, but stock prices declined even so, as ECB policy surprised on the downside. In 2012, the exact reverse was true! With both the Fed and the ECB providing clarity about their determination to support the economy as long as is required, the risk of a deflationary Japan scenario has clearly diminished. Even in Japan itself voices are rising to adopt a much more aggressive anti-deflation stance.

The combination of very low bond yields and reduced systemic risk is undeniably a positive for those risky asset classes which still provide an attractive yield, like equities, real estate, emerging markets debt and high yield bonds.

Even if many brokers are still too optimistic on earnings growth in 2013 (we expect only a few percent growth), the generally positive outlook statements for these risky asset classes are therefore understandable.

Nevertheless, some very important issues remain:
 The fear for policy mistakes by central banks may have diminished, but the same cannot (yet) be said about governments. For example, the fiscal cliff discussion in the US can still cause volatility and so can, for example, the elections in Italy and Germany next year.
 Although we are now witnessing an upturn in the economic cycle in the US and Asia, it is still doubtful whether this will prove to be anything more than just another six month’s swing of the pendulum, in line with the short-cycle environment of the past years.

We think that the chances for the current global upturn to last longer than the previous ones have recently improved somewhat, given the more stable policy environment. But even than equity investors should probably not hope for a substantial economic recovery anytime soon, as that would lead to fears of an end to the easy money policy in 2014.

Such fears would probably overshadow the effect of a rise in expected corporate earnings from low single digit to high single digit. In the current liquidity driven environment for risky assets, equities have the greatest potential for a decent return in 2013 with a world economy which is limping quietly along, without great disruptions.

Sometimes, boring is best.