Investment market update - February 2013

February 2013

UniSuper's Chief Investment Officer, John Pearce, provides a market update for UniSuper members.

2013 is off to a flying start. It seems that the fear of losing money has been replaced with the fear of missing out on a rally,evidenced by a recent acceleration in funds allocated to shares around the world. The switching behaviour of our own membership base has been consistent with this trend as the following graph shows.

Graph 1
UniSuper’s fund flows: Net switches into and out of growth-oriented options

Graph 1 captures the net switches into our accumulation options that have a high proportion of growth assets (such as equities and property) relative to defensive assets (such as cash). Graph 1 could be interpreted as a rough indication of risk appetite among our members who actively engage in switching between investment options. Furthermore, given that UniSuper is a relatively large super fund, the investment preferences of our members are likely to be a rough barometer of the Australian retail investor base in general. Since the GFC, we have experienced four phases of 'risk-on, risk-off', as depicted in Graph 1. 

2013 Outlook

For those who believe in historical patterns repeating, a strong January bodes well for the rest of the year. Referring to the (more comprehensive) US data, there have been nine years since 1960 in which the stock market rose by more than 5% in January. In these years, with one notable exception, the market rose by an average of 23%. Caution: the notable exception was 1987 when the stock market crashed in October of that year.

Of course, nobody knows if 2013 will prove to be a positive or negative year for the stock market. For that reason, we reiterate the past is not a reliable indicator of the future. Investing involves making a judgement of probabilities depending on the prevailing—and expected—market conditions. It is my view that, on the balance of probabilities, 2013 is likely to be a positive year for share markets. That said, there are several concerns and key risks over the next year and these are outlined below.  Last month’s CIO report outlined the key drivers underpinning the strong markets in 2012. The main conclusions were discussed in more detail in a webinar presented on 31 January.

To summarise these main conclusions:

• 2012 was a year in which poor economic fundamentals were outweighed by very supportive financial conditions. In particular, sub-trend global GDP growth and high unemployment were more-than offset by a flood of liquidity and attractively priced assets.  
• While very favourable financial conditions prevailed throughout the year, confidence was still largely absent until the latter part of the year. When people’s worst fears were not realised, sentiment sharply turned positive towards the end of 2012 and hence the strong rally. 
• Very supportive financial conditions are expected to remain in place for 2013. The European, US, and Japanese central banks have made it clear that they are committed to providing high levels of liquidity and low interest rates. Indeed the most powerful central banker of them all, Ben Benanke, has made the extraordinary commitment to maintaining loose monetary policy well into the recovery phase of the US economy. Interest rates are at historical lows across most, if not all, OECD countries. Also, while it’s true shares aren’t as cheap as they were six months ago, valuations still look far from stretched, particularly relative to defensive assets.Following is a graph (Graph 2) that many will be familiar with, showing Australian dividend yields compared to bond yields.

Past performance is not an indicator of future performance.

Graph 2 shows that dividend yields are still well above bond yields, although the gap has been closing with the recent rally in share markets and the sell off in bonds. Given that equities have potential for capital growth, and the best you can do with bonds if held to maturity is to get your money back, it is highly unusual for equities to be returning higher rates of income than bonds. Either shares are cheap, bonds are expensive or dividends are about to be substantially cut; or it’s a combination of any of these. Time will tell, but I find it very difficult to envisage a dramatic cut to dividends in the absence of a recession in Australia. 

Comparing dividend yields to bond yields is a simple measure of relative value. Critics will argue that the measure does not tell us whether equities are cheap or expensive in an absolute sense. While this is a valid observation, shares also appear to be cheap if we compare current dividend yields to historical averages. 

In summary, the supportive financial conditions (ample liquidity and attractive valuations) that drove share markets over the recent past still prevail. Furthermore, there is a growing consensus that global economic fundamentals are improving in the major economies of China and the US. While the same optimism does not extend to Europe and Japan, there is at least a growing consensus that conditions will not deteriorate.  

A combination of supportive financial conditions and improving economic fundamentals is ideal for share markets, but of course there are risks and following highlights my major concerns over the next year.

Key Risks in 2013

European woes continue to dominate the narrative of those commentators with a negative outlook for the global economy and markets. Somewhat ironically, I don’t see Europe being the potential source of the major shocks, mainly because the market is already quite pessimistic about the region’s prospects. The most severe market reactions occur when shocks are totally unexpected, or when the risks are well documented yet the markets remain too sanguine. On this basis I would rate the following three as my major concerns:

1. A full-blown currency war among the large countries, leading to widespread use of capital controls and other protectionist measures. The latest entry of Japan to the ’currency debasement’ game is a major development, with potentially serious consequences for other export countries.  
2. A breakout of inflation in China, necessitating tightening measures to slow down the Chinese economy. Inflation is anathema to a ‘harmonious society’ so the considerable financial firepower the Chinese have at their disposal is highly unlikely to be deployed if inflation reignites. The potential impact on growth is significant given China’s reliance on public sector investment to sustain itself. 
3. A geo-political shock that directly impacts oil prices or global trade. Note that not all geo-political shocks have a lasting negative impact on markets. However, an escalation of tensions between China and Japan, or between Iran and Israel, would be unequivocally bad for market stability.   

While none of the above are likely to be anyone’s base case expectations it is my view that (a) the potential for any of them happening and (b) the impact from such an occurrence is probably underestimated by the market.

One of the best descriptions of risk I have come across is “more things can happen than do happen”, and the markets are obviously susceptible to major shocks outside the three mentioned above. There is also the possibility that in 2013 we don’t experience any negative shocks of major proportions. Let’s hope it’s the latter.

Past performance is not an indicator of future performance. This information is of a general nature only and may include general advice. It has been prepared without taking into account your individual objectives, financial situation or needs. The above material reflects UniSuper’s view at a particular point in time and may change as further information becomes available. UniSuper’s investment strategies and analysis will not necessarily be appropriate for other investors. Before making any decision in relation to your UniSuper membership, you should consider your personal circumstances, the relevant product disclosure statement for your membership category and whether to consult a licensed financial adviser. This information is current as at 7 February 2013.