Equities are set to be favoured in the latter half of 2013 as investor preference shifts away from income generating assets towards growth oriented assets, according to ING Investment Management.
In its annual Mid-Year Outlook for 2013, ING IM observes that this shift in sentiment began in late April and persisted during the recent market correction. Furthermore, contrary to the first four months of the year, cyclical sectors largely outperformed defensive sectors in the equity markets in May.
Valentijn van Nieuwenhuijzen, head of strategy at ING Investment Management, says: “Next to defensive equity sectors, other previously popular ‘yield’ plays like real estate equities and fixed income assets came under significant pressure. However, over the next couple of years, equity returns will start to firmly outperform fixed income returns and global reflation and higher interest rates will create more regulatory room to move towards higher equity allocations for pension fund managers and insurance companies. This will signal a reversal of the massive relocation of savings into fixed income assets ‘forced’ on institutional money managers by the combination of financial crises and regulatory changes over the past 15 years.”
The investment manager notes that stable growth stocks in defensive sectors such as consumer staples and healthcare had seen strong inflows over the past few years thanks to their stable growth characteristics and attractive dividend yields. However, with these equity valuations increasing substantially, a correction has now taken place and, investors are shifting away from these stable, income-generating but expensive equities towards more attractively-valued cyclical companies which offer growth at a reasonable price.
Van Nieuwenhuijzen says: “We believe that the trend towards cyclical companies could continue. Aside from the valuations and the current relative underweight in investment portfolios, there are a number of other reasons for our outlook. For instance, due to the upturn in economic data, there is again an upward trend in economic surprise indicators in the ten largest developed economies. Historically, there is a strong correlation between this indicator and the relative performance of cyclical sectors. We are also seeing yield curves steepening, which is also positive for cyclical and value equities. Finally, the earnings momentum of cyclical sectors versus defensive sectors has recently also returned to being positive.”
Overall, ING IM believes that its base case economic outlook of a consolidation phase followed by a renewed acceleration in the second half of this year remains intact. It notes that economic data in the developed world has started to improve recently with Japan standing out positively in this respect, being the region with the biggest improvement in economic surprise data. Also, both the US and Eurozone have shown signs of improvement since May although emerging markets continue to lag with a continuation of disappointing economic data coming out of China.
On a regional basis, ING IM views the correction in Japanese equities as a temporary phenomenon and expects the Japanese market to return to outperforming equity markets in other regions. Both with respect to economic and earnings momentum, the investment manager maintains that this market enjoys the highest scores of the three main regions (US, Europe, Japan), while its monetary and fiscal policies continue to form a major boost. ING IM also expects foreign investors to continue to allocate money to Japanese equities and, although private Japanese investors are still hesitant about entering into the market, ING IM expects this to change.
In terms of emerging markets, ING IM suggests that one of the victims of the market correction is emerging market assets, suffering from outflows due to less favourable carry trade opportunities and weak Chinese data. However, more structural issues have risen to the surface too, and the investment manager has underweight positions in both emerging market equities and debt.
Maarten-Jan Bakkum, senior emerging market strategist at ING IM, says: “In the developed world, we have seen more structural change since the outbreak of the global financial crisis, which creates room for positive growth surprises compared to the emerging world. The combination of better economic data in the US and disappointing growth in China is clearly negative news for emerging markets. Growth in emerging markets in the past years has been driven primarily by Chinese demand and carry-trade-related flows. Both sources of growth are coming under more pressure now; the former because of increasing evidence of the structural slowdown in China and the latter because of increasing market nervousness about the Fed’s QE policy.”
ING IM highlights that structural negatives, such as large current account deficits, unsustainable subsidy schemes, negative competitiveness trends, regulatory uncertainties and counterproductive state intervention in the economy should determine which emerging markets will suffer the most. At the same time, with the key investment themes of the past few years losing strength or perhaps even disappearing – Chinese demand, flows to high-carry emerging market debt, for example, – the investment manager expects investors will be looking for new themes with a new reform momentum being one.
Bakkum says: “Emerging market countries that are able to increase their endogenous growth potential by tackling their main structural issues have a good chance of escaping a multi-year bear market. Currently, in the whole emerging world, our view is that Mexico is the only country with a credible structural reform momentum. For this reason, it has a good chance of escaping the gradual erosion of domestic demand growth that we expect for the emerging world as a whole in the coming years.
“In sharp contrast with Mexico we find countries like Russia, South Africa and Brazil, where macro imbalances are widening, the investment climate is deteriorating and industry competitiveness is declining. Currently, we see a poor reform momentum throughout the emerging world and few indications that things are improving.”