Growth required to sustain equity progress

Whereas last year a significant pro-equity stance was helpful for performance in multi-asset mandates, bonds have done somewhat better since the start of this year and we can expect the current environment of low inflation and strong monetary policy support to continue over the next few months. But the arguments for preferring stocks remain intact. Thus, equity valuations may be full in some markets but they are by no means seriously overstretched, suggesting that there is room for further positive progress before investors need to worry about a major reversal absent any unanticipated deterioration in the current supportive economic and policy environment. And although news on global growth has been somewhat disappointing and political developments in a number of emerging market countries are concerning, we see the risks of a significant economic setback in any of the large economic areas as low, supported by the prospect of ongoing aggressive policy support from the major central banks for at least the next quarter or two.

Apart from the absolute value of equities, the relative arguments are significantly supportive of a pro-equity stance, especially given yields on bonds and so-called spread products are unusually low, as a result of both central bank agendas and investors’ pursuit of yield. Meanwhile re-weighting to equities by investors is still in its relatively early stages and should continue in the steady-as-she-goes economic and policy environment that we expect. But whilst the arguments in favour of equities in a multi-asset context are clear, recent stock market performance limit the likely scale of any future out-performance and there has not been a correction of 10% or more for nearly two years, which is an unusually long time and on some measures prices are positioned only for good news. Thus, investors pushed up valuations last year with the expectation that systemic risks such as collapse of the euro and US fiscal disaster has passed, leaving growth now required to justify further progress and whilst recent weak data in the US and Japan are seen by bulls as pauses down to one-off factors such as inclement weather, realistically the probability of the data disappointing is about as high as the chances of out-performance.

Moreover, after the sell-off last year, bond yield curves are now reasonably consistent with the current macroeconomic and policy environment. This means that risk-free bonds would likely respond symmetrically to up- or down-side growth surprises and therefore can be expected to provide some protection against an equity correction, as they did in the setback in January, but the problem with bonds is that real yields to maturity are still pitifully low and well below the real rates of returns investors require to meet real liabilities. But within equities we are cautious, given that intermediate-term growth prospects are not clearly strong with potential growth rates falling in many economies on the back of deteriorating demographic trends. Easy money policies are supportive of financial markets but monetary policy cannot in itself drive faster growth, and for long term and sustained stock market progress we do need confirmation of faster growth and improving productivity.

On the growth front, investors have spent the last couple of months worrying about a new emerging markets (EMs) crisis that could pose systemic risks across global economies and financial markets, and there were large capital flows out of many developing countries, putting pressure on currencies and financial asset prices. But we do not expect collapse of EM economies and instead regard investor flows out of EM as reflecting the natural evolution of the business cycle and reasonable expectations about the forward outlook for global monetary policy. Such shifts are essentially healthy, heading off the risk of a more precipitous decline in EM asset prices from much higher levels, which could have produced a more generalized market sell-off and a real crisis. That said, we do see China as the biggest risk to global growth and financial stability, although the context for the current ructions is China’s own policy focus on reforming its economy and financial markets in a manner that is intended to avoid a potentially much more abrupt (and perhaps disastrous) slowdown in the years ahead and to smooth the transition, China has both fiscal and monetary policy flexibility. And whilst we anticipate that it will be increasingly difficult over the medium term for Chinese policymakers to balance structural reforms with ongoing rapid growth, there’s comfort that growth has recently surprised modestly on the upside in Europe, including in the UK.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla