Rational exuberance as investors rebalancing from cash albeit begrudgingly says J.P. Morgan Private Bank

3rd September 2013

Investors are rebalancing their portfolios from cash though the process has been a begrudging one says Richard Madigan Chief Investment Officer at J.P. Morgan Private Bank.

In a note to investors, Madigan characterises this as “rationale exuberance” as investors are not chasing markets. He argues that investors need to be balanced in their approach to investing, which seems more important than ever  in a low growth and low inflation world.

In a note, he adds: “Most of the out-performance this year from equity markets has come from multiple expansion, as investors feel more confident about a low inflation world. But so far, they’ve focused on the United States and more defensive dividend-paying stocks. Cyclical sectors globally have lagged, and we believe they will play catch-up over the next 12 months to help drive markets higher. Earnings growth will be essential.”

“For this part of the investment cycle, equity markets are expected to continue to outperform fixed income. Credit markets will likely offer modest returns, and longer-dated bonds will likely offer minimal, and eventually negative, returns.”

“After five long years, the cult of equity is gradually returning. So far, this year looks like a melt-up year for equity markets. If we finish the year significantly higher, we are likely pulling 2014 equity market performance into 2013.

The note also points out the likelihood that Ben Bernanke’s term is up in January 2014, and says it appears it will be his last. “If this is the case, markets are likely to test a new Fed Chairman early next year. Fixed income market volatility will ripple through risk assets as rates rise, especially if they are seen as rising too quickly. Fixed income markets lead risk assets, so we’ll continue to closely monitor Fed activity and inflation expectations. As we have seen from recent fixed income market tumult, tightening cycles create broad market turbulence. We don’t expect inflation pressure to challenge loose central bank monetary policy until after global growth meaningfully reaccelerates. Now markets have embraced it—which is what has been driving the recent pace of market exuberance.”

Madigan has also pulled together this assessment of markets and sectors.

1)      U.S. equity markets

While the public sector continues to act as a drag on U.S. growth, recovering tax revenues and property markets, not to mention a lower fiscal deficit, have made for less of a drag ahead. Earnings so far remain supported by strong margins, but without top-line growth, corporations continue to hold back on capital expenditures, investment and hiring. We continue to favour mid-cap stocks as merger and acquisition activity increases. We see opportunity in technology and financials, particularly in the big banks, which may offer secular opportunity well into next year and help drive market performance ahead. More cyclically, we like energy as well as industrials.

2)      Emerging Markets:

We were disappointed about emerging markets in the first half of this year, yet continue to view these markets as compelling in the longer term. Emerging economies are expected to grow between 5% and 6% in 2013, led by Asia. Inflation has been a concern, but has remained benign so far. Earnings should grow by high single digits, and valuations, relative to developed markets, are at levels not seen since October 2008. Emerging markets currently offer the highest risk premia across global equity markets, which we believe investors will recognise as they rotate from defensive to more cyclical markets. We expect regional differences to continue to drive performance dispersion. In our view, markets such as Korea will have a more difficult time addressing a weaker Japanese yen, given the quality of its exports and overlap of trading partners, than say India.

For emerging markets more broadly, investor interest has been stymied by headline scares around China that dramatize slower growth. We expect China to continue its transition to more balanced growth, around +7.5% this year and next. China is evolving toward a more developed economic model, one that is far less reliant on manufacturing and exports, and more focused on structural reform, a growing service sector and domestic consumption.

3)      Japan

The most significant first-half event has come from Japan and the force with which Prime Minister Abe has attacked deflation. If Ben Bernanke has been called “helicopter Ben” for the amount of liquidity the Fed is throwing at capital markets, Prime Minister Abe may be nicknamed “rocket man” before his quantitative and qualitative monetary easing experiment is over. It isn’t obvious that he will succeed, but to date it has been a boon to Japanese corporate earnings, driven by a weaker yen. The pace and size of the yen’s depreciation has been surprising to markets. While our FX team continues to see a weaker yen ahead, the pace of depreciation needs to slow. If not, we may see increasing signs of frustration from countries such as China, South Korea, Taiwan and Germany as Japanese currency depreciation is eventually met with direct currency market intervention. Simply put, Asia and Europe could decide that their foreign reserve currency holdings should include more yen and begin to buy the currency to stop the pace of depreciation.

While our portfolios hold investments in Japanese equity markets, we remain modestly underweight Japan. While both the weaker currency and stronger equity markets are momentum trades, they are consensus views, predominantly driven by trading accounts. Japan needs to find a way to address its corporate culture, which has never really favoured equity investors, with a series of reform initiatives that help drive earnings, wage growth, merger and acquisition activity, and investment. So far, we’ve really only seen expectations help drive sentiment higher and a weaker yen boost profitability.

4)      Commodity markets

We expected commodity markets to be driven by idiosyncratic opportunities this year, with a pause in the broad commodity cycle. In a low growth, low inflation environment, with China transitioning to a more balanced economy, we expect the marginal commodity buyer to have far less impact on demand and commodity prices this year. Our commodities team remains constructive on oil as well as palladium. We have moved to an underweight position in our commodity allocation, trimming gold. While we believe in gold as a risk diversifier as well as dollar and tail-risk hedge, we have always been concerned about the weak investment hands introduced with the creation of exchange-traded funds (ETFs) for gold and how trading accounts use them. We continue to recognize that the most relevant holders of gold are central banks. Central bank holdings of physical gold dwarf holdings in ETFs by +10x to 12x; they are strong hands and have been adding to physical gold holdings this year. Right now, the risks remain uneven for gold, given a low growth, low inflation and stronger U.S. dollar macro environment.

5)      Traditional safe harbour assets are becoming higher-risk investments

Looking ahead, we expect investors in long-duration fixed rate bonds will likely lose money as interest rates gradually move higher. We have already seen some turbulence in U.S. fixed income markets this year. Investors need to recognise that the traditional low risk and safe harbour offered from long-duration bonds are transitioning to higher-risk investments. Bond markets are likely to begin to reprice ahead of actual inflation. Right now, the market environment remains supportive for credit markets. Accommodative monetary policy from central banks, in the form of quantitative easing, has pushed yields toward record lows and created a shortage of high yielding assets, a phenomenon exacerbated by Japan’s recent aggressive entry into quantitative easing. With upside mostly limited to coupons, we are closely watching for any warning signs in credit markets. We came into this year expecting a more muted return profile in credit investments compared to 2012 and, so far, asset class performance has been broadly in line with expectations.


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