The banking crisis in Cyprus reminded investors that the potential for policy risk remains. However, risk assets, particularly U.S. and Japanese stocks, continued their advance with many styles approaching double-digit returns for the first quarter of 2013.
Lars Schuster, institutional portfolio manager with Fidelity’s Strategic Advisors Incorporated, and Dirk Hofschire, senior vice president of asset allocation research discuss the markets in their monthly market update.
Schuster: Let’s review the past month, March 2013, in the markets.
Hofschire: We’ve had more gains in some of the year’s best performers, including U.S. stocks and Japanese stocks, which have done very well. But we’ve been a little bit more mixed overall in the asset markets. Bonds across the board have been somewhat flat, and emerging market stocks and commodities have actually been somewhat weak. So, we’ve had a market environment that hasn’t had a lot of volatility. As we come to the end of the quarter, as you mentioned, it’s really been a pretty good one for a diversified portfolio, and a lot of those gains have been spearheaded out of the strong gains we’ve seen in U.S. equities.
Schuster: Consumers are still pretty resilient as far as spending. U.S. housing continues to recover. Why is this happening, even in the face of continued policy risk for the U.S.?
Hofschire: There certainly is still policy risk, but I think underneath all the headlines, all the dysfunctionality that we’ve seen out of Washington, we have been getting some fiscal progress. Our deficits are now lower, and we’ve had less brinkmanship in terms of the tone coming out of Congress and the White House. They’ve actually now passed continuing resolutions that take us through September in terms of the budget. So, some of the things that were on our radar screen for the end of March, or early April, such as the possibility of government shutdowns, and other flare-ups in the fiscal debate, aren’t happening right now. In the long term, we still need to make progress, we’re not sustainable in terms of entitlement spending, and certainly over a longer period of time. But in the near term, there has been progress.
So, as we look at the U.S. economy and how it’s been holding up, I think consumer spending has been surprisingly strong in the first two or three months of the year, despite higher payroll taxes, and higher taxes on upper income tax brackets. We do have sequestration cuts kicking in from now through the rest of the year, and that’s going to have an additional fiscal drag. But I think the overall tone, the strength that we’ve seen out of the housing market, and the improvement continuing in the labor markets, has given the consumer sector a little more strength, and probably the ability to weather this. So when you combine that with improving visibility on taxes, and businesses appearing to be picking up their capital spending, the U.S. economy as a whole appears to be doing reasonably well, a sort of solid mid-cycle expansion.
Schuster: So some positive trends here in the U.S., but clearly a different sort of issue over in Europe. This past month, it seems that the policy risk was Cyprus. What’s been happening there?
Hofschire: There has been some fundamental structural improvement in some areas of the eurozone periphery. So, despite really severe recessions in places like Spain, Greece, and others, we’ve seen some underlying improvements. The eurozone has current account surpluses now for the most part, which means they need less financing from abroad. They have more competitive labor sectors; they’ve seen some of their labor costs go down. So, there has been some underlying repair in Europe.
But as you mentioned with Cyprus, one of the things that hasn’t happened is the financial risk—the overall policy risk—hasn’t been completely removed. And Cyprus is a perfect example of the weaknesses that still exist in the eurozone banking system. In Cyprus, it’s a bit of a unique situation. It’s a very small economy with a very large banking sector, one that’s many times the size of the economy. So when they run into problems, they need a relatively large bailout, relative to the size of their economic ability to pay it. So, creditors like Germany and others want to, of course, minimize the size of that bailout. They eventually ended up bailing out all the shareholders and creditors of a few of the major banks, and even some of the uninsured depositors in the banks. This was the first time depositors of any kind had been considered to be a part of the overall banking sector, taking some of the pain of the banking crisis. So, it’s not so much Cyprus now, but it’s the lessons for what’s going to be seen going forward with the eurozone. And certainly this is going to increase some banking risks throughout the rest of the region. People are going to be more worried now about the banks, and wondering who will have to take the haircut if more banks get into trouble. When the banking system is weak, that’s going to continue to impede the recovery across the entire continent.
But at least for now, when you think about it in terms of the global financial markets, and the systemic risk for what it could mean for the entire world, the markets have actually held up pretty well. So in my opinion, it does increase some risks, and makes Europe a little bit more of a concern. But it doesn’t look like its rising back to a fever pitch.
Schuster: Let’s keep moving across the globe to Japan. We’ve continued to see a move forward in Japan, from a stock perspective.
Hofschire: As we mentioned last month, they have a new prime minister, and Abe is trying to implement his three-point plan, now that he’s in office. The first one is for monetary policy to be very stimulative to try to end deflation. The second one is more fiscal stimulus. And the third one is structural reforms. These policies are aimed at trying to get Japan out of a two-decade malaise that’s been deflationary, and has inhibited their growth across the board. The monetary and the fiscal stimulus have already started to boost near-term sentiment. The yen has depreciated, which helps their export sector, and their stock market has gone up. So, I think that there’s some real fundamental change in the way even the Japanese are viewing their economy. This is starting to have virtuous benefits in terms of getting the activity going. The last pillar of the plan, the structural improvements, includes everything from trade agreements to some labor market reforms that will make their labor sector more productive and potentially increase wages over time. These are structural reforms that’ll take a lot more work, but are probably the most important ones in terms of making this overall environment more sustainable for growth over the long term. So, I have some doubts over the longer term of how effective structural reforms are going to be, but for right now, it’s a lot more momentum in the Japanese economy. It certainly has justified, in our opinion, the run up in Japanese stock so far and gives a pretty good backdrop, at least for 2013.
Schuster: So there have been some positive results for developed market stocks. The United States, Europe, Japan, have not seen the same thing from emerging market stocks. A lot of that, interestingly enough, is happening in the face of growth from some very large emerging markets, like China. So, why are we seeing growth in some of the markets, but the stock side is negative?
Hofschire: Emerging market stocks have been negative so far, year to date at least, in dollar terms. I think there are a couple things going on here. We’ve talked in recent months about how China has emerged into an early cycle phase of recovery, but it’s not a particularly robust one. It is very credit driven, and in many ways, a low quality turnaround. And from that standpoint, it makes it a little more difficult for equity profitability—for corporate profits—and that’s really what the stock markets want to see. When you go beyond China, and look at some of the other emerging markets, the recovery’s been a little uneven. Places like India and Brazil still have relatively high inflation rates, a little more mixed economic progress. The strength of the recovery is not universal across the board.
The other important thing to keep in mind is emerging market stocks did outperform during the second half of 2012, compared to U.S. stocks. And in the fourth quarter, when U.S. stocks were flat and awaiting the fiscal cliff and other concerns, emerging market stocks actually had decent gains. So it’s possible this is just a matter of timing. Emerging market stocks went up last year, and maybe got a little bit ahead of reality, and had some of the good news priced in. U.S. stocks waited. I think the bottom line going forward is that we expect that there’s going to be incremental progress in the global economic environment throughout the year. And if so, that improving global backdrop is probably going to be supportive of emerging market equities, so they may be able to narrow that performance, and do better as we go along.
Schuster: We had the four year anniversary of the March 2009 market lows. As we’re approaching what appear to be all-time highs in many indexes, is this a top? What’s an investor to do at this stage of the game?
Hofschire: It seemed like nobody was interested in stocks for so long—everyone was fearful. Now all of the sudden, we’re all getting worried that we’re approaching index level all-time highs. The first thing is, I think, that index levels themselves are not particularly meaningful. They’re just price levels, right? And if you think about the same price levels we had five, six, or even 13 years ago, it’s not really very meaningful. We would be surprised if most of the things we buy today, weren’t at a higher price than they were five or 13 years ago. So you have to put those prices into some kind of context. The obvious context we use for stocks is against earnings, price to earnings ratios. By that metric, valuations are still pretty reasonable, right within historical average levels. However, it is important to point out that, the sentiment has been better recently, and that means some of the better news about the U.S. economy and U.S. stocks has been priced in. Valuations are worse than they were a few months ago, and especially in some of the other riskier categories, like credit securities, high-yield bonds, and other things.
The profit growth is also slower in the economic cycle we are in, and corrections are not uncommon at all in this sort of mid-cycle stage of the economy. So, we don’t expect that we’re going to get huge early cycle gains like we did back in 2009, or that this is going to be some straight line up in the near term without any volatility. So I think the best thing to do is to continue to think about the fundamentals in the market, but also to keep more of a long-term focus on the strategy.