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Are global equities broadening out?
IN some parts of the financial markets, there are rumblings that a bubble is building up in global equities. Such sentiment is understandable given the impressive returns in 2013 - the MSCI World up by approximately 20 per cent in local currency terms (15 per cent on US dollar or USD basis). Volatility has, meanwhile, been declining as indicated by the low level of the VIX, which some observers have suggested highlights a rising level of complacency among investors.
However, such positive returns have, at worst, tracked the improvement in earnings and economic fundamentals - in line with our global real GDP growth forecast of 3.4 per cent in 2014. From a historical perspective, such returns do not suggest excessive exuberance or that a bubble is in the making.
Besides, the performance of global equities has been unevenly spread across regions, with developed market (DM) equities, in particular the US and Japan, at the forefront of returns.
Their performance was, however, offset by the emerging markets (EMs), including Asia, which has lagged; delivering a muted negative return of about 10 per cent.
The foundations of our outlook
With an improving economic backdrop, investors' sectoral and regional biases are likely to shift as the economy moves from the initial recovery stage to mid-cycle growth. In the initial phase of recovery, defensive sectors (such as consumer staples) and stocks (including dividend plays) outperformed as investors remained tentative about economic growth. The market performance had also been relatively narrow and was driven by a few select markets such as the US and Japan.
However, we are starting to observe changes in performance trends as economic growth becomes more entrenched. As investors become more confident in the recovery, they will most likely rotate from defensive investments to markets that are more geared towards the global recovery. Investors will also be more prepared to pay for growth instead of focusing solely on value.
As such, cyclical/growth stocks are likely to outperform non-cyclical/defensive names. We also expect market performance to broaden, which will result in a higher number of markets delivering positive returns.
Europe: The next momentum trade
While we remain strategically constructive on DM equities, we expect to see a different set of markets driving the rally, with continental Europe coming to the fore. Our preference for Europe stems from a combination of stronger earnings growth and more attractive valuation.
Barclays expects the MSCI Europe (ex-UK) to deliver earning growth of 15 per cent in 2014, which is a significant improvement on the negative growth of 2013. While there are still many issues to be resolved, the worst is most likely over for the region. The European Central Bank's (ECB) surprise interest rate cut also indicates its willingness to support growth - and the ECB probably has the capacity to do more than its US and Japanese counterparts.
Already, we are witnessing active buying from global investors into European stocks. With the region's equities still trading at a wider-than-average valuation discount - relative to its US peers - we could see yet more buying into Europe.
The southern European equities (including Spain, Italy, Portugal) are of particular interest as these markets had underperformed significantly since 2010 when the debt crisis escalated in the region. However, we are beginning to see signs of improvement, such as Spain, which was one of the stronger-performing markets in continental Europe.
US equities have been the favourite market for a while, but could now face increasing competition for investors' funds from Europe. Investors would most likely demand clearer signs of earnings growth acceleration, especially as valuation has become richer. As such, while we do not anticipate a decline in markets, the performance of US equities could pale in comparison to their European counterparts.
As for Japan, the anticipated depreciation of the yen will likely support equity performance, especially in the export sector. Nevertheless, the weaker yen will also continue to affect market returns in USD terms. More importantly, the combination of aggressive monetary and fiscal policies can only bring the market up to a level - and beyond this point, investors will start to demand more visible progress of structural reforms. It remains to be seen if Prime Minister Shinzo Abe can successfully implement the reforms, hence, our continued neutral stance on Japan equities.
Emerging markets may become less contrarian
Contrary to the strong performance of DM equities in 2013, EM equities have significantly underperformed. In fact, EM equities are still trading about 20 per cent below their last peak in May 2011.
Nevertheless, there are reasons to be positive. Valuation-wise, all three regions of the emerging markets, that is, EM Asia, EM Central and Eastern Europe, Middle East and Africa, or Ceemea, and EM Latin America or Latam) are now trading on book multiples that are close to their 2008 cyclical troughs. In addition, Barclays is projecting EM industrial output growth to recover in 2014, which will be supportive of earnings growth and equity market performance.
With improving growth and attractive valuations, investor demand could start to spill over to EM equities.
While overall EM performance could improve, investors would likely continue to differentiate between individual markets' ability to deliver growth and withstand liquidity outflows. As witnessed in 2013, EM countries with significant current account deficit issues have underperformed and may continue to do so until those deficit-problems improve.
While some countries, such as India, appear to be making progress in curbing their deficits, many others remain vulnerable. In comparison, countries with healthier current accounts, such as South Korea and Taiwan, will most likely stay in favour. Barclays's analysis also suggests that earnings growth has been relatively stronger in EM Asia relative to both EM Ceemea and EM Latam - which suggests EM Asia could continue to outperform the other EM regions.
It is also worth noting that a number of EM markets (including those with current account deficit issues) are facing elections in 2014.
These markets could initially underperform due to political uncertainties although selected markets could subsequently rebound after the election, especially if the outcome could lead to meaningful reforms and market-positive changes.
Go north in Asia
Asian markets are set to benefit from the broadening out of equity performance after posting a lacklustre return in 2013. In particular, the prospects are turning brighter in the north of the region, which could help lift the performance of the whole. North Asian equities, as a group, have started to outperform South Asian equities for the first time since the recovery in 2009.
Within North Asia, we are optimistic that Chinese equities will gain more ground as economic growth stabilises and reform initiatives begin to bear fruit. Hong Kong could also benefit from a stronger China, given the close link between the markets. Our bearish view on the Hong Kong property market, however, could offset some of the positive impact.
Investors are also warming to the export-oriented markets of South Korea and Taiwan as they stand to benefit more from the recovery in global growth than their regional peers. In particular, Korea is witnessing a bottoming-out of its property market, which could benefit domestic financial and consumption companies.
Already, there have been strong inflows into Korean equities in 2013, although foreign ownership (estimated at 36 per cent) is still well below the peak of 44 per cent seen over the last 10 years.
The writer is an equity strategist at Barclays