The year has started off with a remarkable burst of optimism in the equity markets. The recent Bank of America Merrill Lynch (BofA ML) survey of global fund managers is full of it. Consider the data: the proportion of investors taking higher than normal risk is at its highest since—hold your breath—January 2004; a net 51% of investors are overweight equities, the highest level since February 2011; growth optimism has surged to a 33-month high; profit expectations are the highest in 22 months; and investor perceptions of liquidity conditions are at their most favourable since April 2011.
Is all this good cheer justified? The World Bank’s report on Global Economic Prospects says while financial market conditions have improved dramatically since June 2012, “the real-side recovery is weak and business conditions low”. Indeed, global growth in 2013 is projected at 2.4%, just a smidgen more than the estimated 2.3% growth for 2012.
Is it just liquidity then that’s driving growth in equity markets? The fact is that the price of risk has come down sharply. Credit default swap rates have come down as have yields on sovereign debt for the European periphery—the World Bank document points out that bond yield spreads for developing country debt are 171 basis points lower than the year-ago levels. The report lists several achievements: fiscal austerity measures have reduced deficits in Europe by 3.3% of the gross domestic product since 2009; bank recapitalization has been substantial; the measures by the European Central Bank have gone a long way in reassuring markets; and unemployment and the housing market in the US are showing signs of a turnaround.
The World Bank believes that in 2013, growth will slow in the US, because of fiscal issues, but also that the contraction in Europe should ease. And developing economies, including India and China, should do better this year than in 2012. Easier monetary policy in developing nations will help growth. The JPMorgan Global Manufacturing and Services Purchasing Managers’ Index was at a nine-month high in December 2012. For India, the World Bank forecast that average oil prices will decline a bit this year is good news, as is the estimate of lower prices for non-oil commodities and an upbeat projection for global trade.
Higher growth in developing economies coupled with continuing loose monetary policy in the developed world will mean more portfolio flows to emerging market equities in 2013, according to the World Bank’s estimate, although it cautions that the ride will be bumpy.
The BofA ML survey for January says that investors are a net 40% overweight emerging markets, which “suggests EM equities are overowned/overbought short-term”. Also, the widening gap between a growing underweight in bonds and the overweight on equities shows the beginning of a “Great Rotation” from bonds to equities. But the survey cautions, “Clearly for risk assets to remain bid, growth and earnings data will need to accelerate before Q2”. The World Bank assessment indicates that is likely to happen.
What about the short-term? In spite of all the optimism, cash levels with global fund managers are still at 3.8%, above BofA ML survey’s “sell” signal of 3.5%. That suggests there’s still some juice left in the rally.