Risk rally, with a hint of caution.
Politics has once again stomped all over a good clean market rally. That said no one in the markets seems to have noticed. Returns for the first month of 2013 have been terrific if you have been prepared to take risk in equities or in commodities. Cotton, bouncing back from a weak 2012, has put on 10.4% in price terms. Corn and Palladium rose 6% while the GSCI commodities index appreciated 4.4%. In equities, G3 equity markets were up between 3% and 6%. The MSCI Frontier Markets index (mostly Africa, MENA, South Asia and Eastern Europe) grew 7.3%. The MSCI Africa index is up almost 12% year-to-date with Kenya, Nigeria, Vietnam and the UAE leading the way.
US high yield fixed income - our only holding in that asset class - put on 1.3% while G7 government bonds lost 1.5%. Emerging Markets credit, measured by the JP Morgan JACI index, dropped 0.5% in total return terms. Their equity equivalents in Latin America, Eastern Europe and South America rose between 1.6% and 4.2%. Equity volatility collapsed again after spiking at Christmas and traditional risk-on currencies made strong gains with SEKJPY up 7.4% and AUDJPY up 6%.
Against this backdrop Italian and Spanish politics once again threaten to undermine confidence. This is not to say that they will, just that investors should be alive to potential reversals. Democracy is a messy but superior political product - if not necessarily economic. In Italy it once again appears that Silvio Berlusconi's star is on the rise and on an anti-Germany electoral ticket. Italy's general election offers the prospect of Berlusconi facing off against technocrat Mario Monti on 24-25 February. Punditry suggests there isn't much to choose between the two in prospective votes terms. A victory for Monti would be a triumph for long-term economic credibility, but the manner in which Berlusconi was removed from power in 2012 would almost certainly require Monti to win by a considerable margin to give him democratic credibility.
And in Madrid, Prime Minister Rajoy is now embroiled in a political scandal over party funding that may or may not have included off-balance sheet payments to senior politicians. Once again, this threatens to make it much more difficult for Spain to offer effective government at a time of sustained economic adjustment and with unemployment rates rarely seen outside undeveloped countries with informal markets. Italy was the largest borrower from the European Central Bank until May 2012. Since then Spain has become, by far, the most prolific borrower. Prime Minister Rajoy will attend the European Union summit on 7 February, thus making European political news-flow important for many weeks to come.
Europe's rifts aside, the news in global markets continues to be encouraging. Perhaps the most positive development has been the move through 2% yield on the US 10-year government bond (both German and US yields have been on the rise since Q4). Normalisation of interest rates will be a key test for the resilience of risk markets over the coming years and the perseverance of moves higher, despite the obvious political risks in Europe, is a positive sign. On the other side of the fixed income market to the US Treasury and European governments will be the G7's central banks with additional Quantitative Easing measures. The combination of low growth and pro-active central banks threatens to make risk-taking a perceived one-way bet.
This is where it gets interesting though since equity volatility remains doggedly low and fund flows data suggests an acceleration of flows into bonds, not a reversal. Data from the Investment Company Institute, which tracks US mutual funds flows, shows flows into fixed income falling away in December but coming back strongly in January. Equities, which have experienced net outflows in every month in 2012 barring February, have reported the largest increase in inflows since February 2007. This is most likely a preference for income returns rather than a preference for moving from bonds to equities. Nevertheless, anyone wishing to continue with a large bias to fixed income should consider doing so through the medium of a fund with sophisticated hedging techniques.
In sector terms, there is now a clear split between sectors that are better value in Developed Markets than Emerging Markets (Consumer Staples, Telecoms, Financials and Materials) and the reverse (Energy, Industrials and Technology). Favoured developed markets sectors also offer lower beta exposure to a political event in Europe. Moreover, cyclicals versus defensives analysis of the US market points towards resurging cyclical stocks, particularly in the financial and construction sectors.
Lastly, a couple of points about FX and Africa. Euroyen continues to rise with little sign of a slowdown in JPY's journey south. Having broken 93 to the USD, JPY is now clear to target 95. Our DCI FX models show GBP significantly over-sold with a solid over-bought signal on EUR in the options market. GBPJPY is probably a better avenue for expressing European strength against yen weakness (31bps of carry). But, in carry terms, AUD, NZD and NOK remain the best options in the G10 majors for trading weak yen. Equally, MSCI FM Africa is now trading at levels where 95% of all index constituents are above their 200 moving day average. Recently we switched our Frontier Markets equity focus from broad FM to the GCC where the Bloomberg GCC 200 index has only 60% of constituents above their 200-day moving average. This still looks a good switch.
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