At the start of 2013, it was fairly easy to see that global equities were undervalued and global bonds were overvalued. But most investors were too busy looking back at the turbulence of the previous five years to do anything about it. After a year of robust returns, investors have now regained their confidence and are much readier to desert bond markets in favor of equities. Sustained earnings growth and reasonable valuations make it likely that equities will continue to do well in 2014, whereas a pickup in economic growth and poor valuations would mean that bonds struggle.
The problem is that this is very much a consensus view, which investors appear increasingly willing to act upon. Experience teaches us that markets usually make fools of those who follow consensus views. The coming year will be no exception. Even if predictions about the overall direction of markets prove correct, the path is likely to be an unexpected one: Markets are likely to be more volatile, the magnitude of moves to be smaller than in 2013, and the composition of an equity advance to be surprising. Most investors will have an uncomfortable ride.
It’s no surprise that most investors are cautious about government bonds. Growth in developed markets is picking up, the Federal Reserve is beginning to reverse monetary easing, and interest rates will eventually rise from rock-bottom levels. Yields have already increased from multicentury lows to nearly 3 percent for U.S. ten-year Treasuries, and the experience of previous cycles suggests they will hit 3.5 percent to 4 percent. Yet this is also very much a consensus opinion, and investor surveys show short positions at near-record levels. Meanwhile, inflation in developed markets is expected to remain well under 2 percent, so real yields will not be miserly. A strong pickup in bank lending looks very unlikely so long as fiscal restraint is universal, thus an uptick in inflation may be some ways off. It will probably pay to buy U.S. Treasuries sooner than the consensus thinks.
In the continuing search for income, high-yield corporate bonds remain a popular trade — identified in Bank of America Merrill Lynch’s December 2013 Fund Manager Survey as one of the three most crowded trades. Yet spreads over government bonds are well below the historical average, issuance is strong, and the prospect of credit upgrades is fading. Most companies that were in a parlous financial position five years ago have since repaired their balance sheets and seen their credit upgraded. It is probably too late for those who haven’t, however. The short duration of high-yield bonds is seen as a positive if government bond yields are rising, but it also means refinancing risk.
Emerging-markets debt, on the other hand, is an unpopular trade. Currencies have fallen, spreads over developed-markets government bonds have risen, and economic difficulties have stirred political unrest. There is still a downside in some currencies, with spreads generous rather than extreme and political uncertainty likely to continue. But the assumption that there must be a financial Armageddon in these markets before it’s time to buy again is absurd. Investors are aware of the headwinds of tightening U.S. monetary policy and probably have already discounted it in prices. Emerging-markets debt may prove to be the best, rather the worst, segment of the global bond market.
After several years of poor performance — underperformance by more than 25 percent since mid-2010 — and an especially disappointing 2013, investors are also giving up on emerging-markets equities with positioning at close to ten-year lows, according to the Bank of America Merrill Lynch survey. Investors recognize that markets are cheap by historic standards and in relation to developed markets but point to a fairly high dependence on resources both in the composition of the market and in emerging economies. Low valuations of government-controlled or directed companies pull average valuations down, and yet these companies are still regarded, deservedly so, as cheap. Low valuations do not mean high, free cash flow as a result of overinvestment.
The contrarian argument is that companies in emerging markets will benefit from past devaluations but currencies should now stabilize. Resource prices have been flat, rather than falling, and will probably continue in 2014 and thereafter. The example of European Aeronautic Defence and Space Co., up more than 80 percent in 2013, shows how the evolution of a company away from government control can be highly profitable for investors. If emerging-markets companies are allowed to follow the same path, they could also be very profitable for investors. Lastly, as growth expectations are curtailed, companies should generate more free cash flow and reward investors more effectively. Emerging-markets equities look much more likely to outperform than underperform.
Emerging markets were an important part of the justification for buying global consumer products companies in developed markets, which benefited from the globalization of brands and prosperity driving consumers upmarket. Eighteen months of poor performance has left many investors disillusioned, but valuations are returning to earth while brand longevity and low revenue cyclicality remain compelling arguments for the sector. It will be worth buying the best-quality names in 2014. At the other end of assumed cyclicality, resource stocks are also out of favor, but resource prices are stable, companies are cutting back on capital expenditures and increasing cash flow, governments are becoming more welcoming, and valuations are low. As strong cash flow repairs balance sheets, companies will be able to boost cash returns to investors. Resource companies’ share prices are discounting too much bad news.
Investors are especially optimistic about technology stocks for which the prospects for growth are good; the overall sector valuation still looks reasonable; and, compared with the turn of the millennium, expectations look favorable. But the companies with the highest quality and most visible growth are getting expensive, whereas the overall average is pulled down by seemingly cheap companies with a glorious past and a challenging future. Investors are also optimistic about banks, whose valuations appear low by past standards and whose fortunes stand to improve. Yet regulation and political fiat have permanently impaired the sector’s profit potential, and banks in many countries have become easy targets for the media, lawyers and taxation. The sector deserves to be cheap.
This year is certain to be full of surprises. Investors overall should have a good 2014, but it’s almost certain to be more challenging than 2013.
Max King is a portfolio manager and strategist for Investec Asset Management’s multiasset team in London.
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