The uncertainty associated with the eurozone crisis has weighed heavily on stock markets. Investors have poured into the safe havens of fixed income, pushing yields on US and German bonds to record lows. Yet, as time has progressed and doomsday scenarios have been avoided, equity markets have switched out of panic mode, and grown accustomed to the possibility of a Greek default and Spanish and Italian bailouts. In my view, these risks are now largely factored into valuations. While we are by no means out of the woods yet, there are more reasons to be cautiously optimistic. The tide is beginning to turn for equities and historically when such a turning point is reached markets can move ahead strongly.
Having been bearish on equities for the last 18 months, I now see growing evidence for cautious optimism on the part of equity investors. The reasons to be negative have been well documented. We have had a banking crisis, economic crisis and sovereign crisis as well as the destabilising potential of the US fiscal cliff on the horizon. The obstacles for equity markets seemed imposing and too large to quantify. More recently however, investors have begun to form a more coherent picture of the risks and there is growing confidence that there is a navigable path through the present headwinds.
Previously, I said the key risks to equity markets were bank deleveraging, policy inaction and political risk related to the eurozone crisis, and commodity prices. Encouragingly, these risks have been recognised and either mitigated by a growing acceptance among policymakers to undertake the right actions, or priced into equity valuations or, in the case of commodity prices, risks have subsided due to a mix of demand and supply factors.
While some agricultural prices have moved higher due to poor harvests in the US, industrial commodity prices, including oil, have moved notably lower over the past 6 months. Lower prices do not only reflect weaker demand - it appears that increased supply is also playing a part, with shale gas developments being instrumental in bringing down US natural gas prices. Meanwhile, the more unified, committed tone of Eurozone policymakers has becalmed investors, with both Monti and Draghi assuring markets that everything that can be done will be done, as we move incrementally towards closer eurozone banking and fiscal integration.
While myriad risks persist, we need to recognise that many of these outstanding concerns are now reflected in equity market levels. We can see this in the defensive positions taken in equity markets by our clients, who have shown a clear preference for fixed income products for a considerable period of time. The humility being shown towards equities has been justified, but equity markets have a habit of moving back out of the shadows when they become most overlooked.
There are five reasons to be more positive in my view:
- Across the world, interest rates have been declining for some time.
- Governments globally have pursued expansionary monetary polices and longer-dated bond yields have collapsed.
- As a result, a more compelling case exists for equities, which now offer virtually across-the-board higher dividend yields than their respective bond markets.
- Recent falls in equities have occurred with reduced levels of volatility and markets have stabilised at key support levels.
- The leadership of the equity markets when they do rally is encouraging; markets are not being led by high-beta stocks within commodities or banks.
The last point on market leadership is worth expanding on, as I think it is particularly noteworthy. Rotations in market leadership are historically associated with market turning points. Recently, market leadership has shifted to companies in the consumer, healthcare and technology sectors. Unlike commodities, these stocks offer a store of value with a dividend stream, and this preference makes us more confident that investors are buying equities for the right reasons.
While I recognise that there are still significant risks to be overcome in the next six to nine months, I believe this shift in leadership indicates that we have moved into a more constructive phase. Markets are rising for the right reasons - income and security - despite the well-documented risks. With the prospect of significant downside in equities receding, I think markets now have an opportunity to build on what appears to be a consolidating platform.
Even with the US fiscal issue still outstanding, US bond yields suggest that most of the investors who wanted to get out of the equity market have already done so. In summary, I feel a lot of the reasons for not owning equities have become well-established and well-embedded within current valuations. I think the time has come to stop thinking about selling equities and to start thinking about buying them.
Dominic Rossi is Global Chief Investment Officer, Equities at Fidelity.
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