Equity markets started 2013 with more than their usual bout of new year enthusiasm, buoyed by an improvement in investor confidence and tentative signs that the global economic landscape may be stabilising.
The latest fund flow data suggests that this year may be the start of a "great rotation" out of bonds into equities, as risk aversion declines and investors focus more closely on the minimal inflation-adjusted returns available on cash and government bonds. The S&P 500 Index finally broke through 1500 for the first time in over five years and three quarters of S&P 500 companies beat analyst forecasts for fourth quarter corporate earnings. However the payroll tax hikes agreed as part of the fiscal cliff deal could prevent a strong resumption of US economic growth. Valuations in many sectors are looking quite stretched, but for the first time in many months this hasn't stopped equity funds from attracting more inflows than bond funds.
Rocky road continues
UK equity markets have made a particularly strong start to the year, despite renewed signs that 2013 is likely to be another tough year for the British economy. Provisional data showed that GDP contracted 0.3% in the final quarter as temporary factors that boosted growth in the summer, faded. Despite a positive rerating in 2012, UK market valuations still compare favourably to many of its developed peers, including the US and Japan. Gilt yields have crept back up to around 2%, but are still low by historical standards. Combined with near zero interest rates at the bank, demand for income is likely to remain a dominant theme this year. Small and midcap companies remain relatively inexpensive, and there are tentative signs that the valuations of cyclical and defensive stocks are starting to converge once more.
Signs of healing
Sentiment towards Europe continues to improve as the economic data for the region, while still poor, shows signs that the European Central Bank's (ECB) actions over the last 12 months have brought a period of relative calm. Many investors believe this paves the way for leaders to get the single currency project back on track. However, negative reaction to the deadlock in the recent Italian general elections is further evidence that markets are likely to remain focused on the political issues facing the region. The ECB released data showing that European banks (278 in total) plan to pay back around €137bn of the €1trn in loans issued through the central banks' LTRO programme. This suggests that the troubled European banking system is beginning to heal and confidence is returning to the interbank lending market. Equity market valuations look attractive on a relative basis and if the evidence of the economy bottoming out persists, it could further improve investor sentiment towards the region.
Expectations running high
Growth of 2% of the Chinese economy in the final quarter meant full year growth in 2012 was 7.9%, beating forecasts and confirming that the economy had bottomed in the third quarter. The measure of success for the new government will be evidence of wealth transferring from the state to households, while keeping potential social unrest to a minimum. Attractive valuations and government reforms to improve access to equity markets by domestic and foreign investors should support Chinese equity markets. In Japan, there are high expectations of Shinzo Abe's Liberal Democratic Party with his pledge of reining in the yen and tackling deflation. So far markets have responded positively, with the yen falling around 15% against the dollar and Japanese equities continuing to rally. The pressure is on to maintain the pace of stimulus and any signs of slippage are likely to produce disappointment in the financial markets.
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