At the start of this year, market analysts in North America were strongly convinced that U.S. equities would underperform in 2015. This view was based in part on predictions that after five years of U.S. stock market outperformance — by some 18 percentage points over the rest of the world last year — markets would finally show mean reversion. Also, observers anticipated that quantitative easing by the European Central Bank would help revive the economy of the euro zone.
Our global equity team at Investec Asset Management was not quite so sure. U.S. equities might, on average, look expensive. But there are plenty of high-quality companies offering reasonable value and good earnings momentum that were delivering good shareholder returns. The team’s portfolios were slightly underweight the U.S.; however, exposure was raised close to neutral during the first half.
Although the U.S. did underperform in the first half, returns were still positive, whereas most of the apparent returns from euro zone equities were wiped out by currency weakness. The best returns came from Japan, where the market looked stale from the top down but a growing number of companies offered an attractive combination of good value, improving earnings growth and an increasing focus on shareholder returns.
In our view, this shows that in a year when so much attention has been paid to macro issues such as China, Greece and Federal Reserve policy, the most abundant source of returns has come from picking the right equity themes and the right stocks. Over the past six years, many investors have sold active equity funds and bought passive exposure. On average this year, those who have invested in active funds have been rewarded, and we believe they most likely will continue to be.
Conventional wisdom has also been turned on its head in regard to asset allocation. Equity returns have been modest, but they have been positive, and volatility has been low. Developed-markets government bonds — the historically defensive, low-risk asset class — have delivered negative returns that have been volatile. The bull market in equities is now more than six years old, and the business cycle not much less. This is already one of the longest periods of business expansion in history, while the equity market has not had a significant setback since 2011. Naturally, investors are wondering how long this can continue.
The answer — we think — is quite a while. Economic growth has been more moderate than in previous cycles, and there is no sign of the overheating that usually occurs late in the cycle when credit growth is booming, inflation picking up and growth accelerating. Equity markets have not been driven above the long-term historical average, despite unusually low interest rates and bond yields and no excess of optimism. There doesn’t seem to be a rush of money into the market either. The gloom of six years ago has dissipated, though the euphoria normally seen at market tops is notably absent. Moreover, Bank of America Merrill Lynch research released this month suggests that bull markets do not die of old age.
We believe that the second half of 2015 and at least the first half of 2016 will offer more of the same: steady economic growth, continuing low inflation and a pickup in the growth rate of corporate earnings. This will improve the valuation of equities, and in response markets will probably rise steadily, in our view. Bond yields could drift higher, but the first half’s performance looks more like a retreat from overvaluation than the start of a sustained bear market. There will be plenty of macroeconomic worries, mind you. But, although geopolitical issues will dominate the media, it could be far more rewarding for investors to spend their time and energy seeking out opportunities to add value through thematic, stock and credit selection.
Max King is a portfolio manager and strategist for Investec Asset Management ’s multiasset team in London.
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