IN GBP terms, global equities have risen by 5.8% over the last three months. In local currency terms, the Japanese market outperformed during this period, recording a gain of 16.5% compared with a 3.7% rise for the UK market. Emerging markets underperformed, recording a loss of 3.6%.
Despite the increased volatility into the end of May, the FTSE All Share Index finished 2.5% higher for the month and hence records a pretty astounding 12 consecutive months of gains.
Cyclical sectors lead the way in May, with the General Retail sector and Automobiles recording strong gains over the month, whilst defensive sectors such as Beverages, Food Producers and Utilities all lagged.
This shift is notable in itself, with clear signs on both sides of the Atlantic that the latest leg in the equity rally is being driven more by cyclical than defensive names. To an extent this was inevitable – with a lacklustre set of earnings releases through the latest UK earnings season doing little to move forward forecasts, there was a limit to the extent that further multiple expansion of defensive growth names alone could be relied upon to drive the index higher.
This performance disguised a notable increase in volatility towards the end of the month. This was driven partly by fears that the Federal Reserve (the US Central Bank) could be close to reducing the scale of its asset purchase programme in the months ahead.
Indeed, the most recent set of Federal Reserve minutes indicated that a number of central bank officials expressed a willingness to reduce the size of monthly asset purchases in the near-term (currently $85bn per month), while a few also expressed a concern that conditions in certain US financial markets were becoming too buoyant.
The probability of purchases being “tapered” in the months ahead has therefore increased, with Ben Bernanke recently indicating that this could happen by September if economic conditions continued to improve.
In response, US treasury yields and mortgage rates have recently increased to their highest level in over a year (May was the worst month for US Treasuries since December, 2010). There have also been increasing concerns over whether the Bank of Japan can successfully navigate its own policy of Quantitative Easing, with volatility in the Japanese equity market being particularly noticeable.
We do not believe that an early withdrawal of QE in the US is a reason to worry that US bond yields will shoot through the roof, starving the equity market of oxygen. What is QE after all? It is simply the monetary authorities standing in for overly-cautious or temporarily malfunctioning financial markets by directly buying both government debt and consumer loans (treasuries and mortgage backed securities).
The budget deficit in the US was recently revealed to be decreasing rapidly. With financial institutions more positively inclined towards lending, reduced demand from the Fed should on the one hand simply mirror reduced supply of bonds from the treasury and on the other hand be replaced by a reinvigorated banking system.
Some commentators have worried that markets are rising too fast. We should welcome the current turbulence as a chance for investors to take a step back, reflect on what has happened over the past six months and to reassure themselves that the extraordinary gains being seen are in fact rational and not just based on momentum and the most dangerous rationale of all, peer group pressure.
In every year since 2010, stocks have performed very well in the early part of the year, only to then suffer setbacks. Whether such a reversal is repeated this year remains to be seen.
Nevertheless, we remain optimistic that conditions will remain supportive for “risk assets” over the 12-18 month investment horizon.