“Improving economic data suggests the global economy continues to recover, which is pushing analysts to increase their estimates for company profits,” the Rothschild report said, noting that Federal Reserve stimulus might be propping up the economy, which has limited usefulness. “Broadly accommodative central bank monetary policies provide additional support. However, this situation indicates that the business cycle is entering a later phase. If the economy is improving then interest rates and inflation are likely to rise at some point, which would in turn dampen potential profits.”
Rothschild: Impact of quantitative easing
In regards to quantitative easing, “the Fed has been more aggressive with quantitative easing (QE) than other major central banks except in Japan. As a result, the dollar has weakened, which has supported company earnings and share prices.” But does this Fed support of the markets have limitations?
When considering US equities and potential over-valuation, the report notes both positive attributes in the housing markets and caution signs. “Along with the rise in US equity markets over the fourth quarter, the country’s house prices have also continued to increase,” the report optimistically noted. “As a result, household wealth is now meaningfully higher than it was during the 2000 equity bubble and close to its 2007 peak. In addition, most US households have reduced their debts and improved their balance sheets, which is positive for economic growth.”
But has a stimulus driven wealth bubble taken equity market prices significantly past market value? The Rothschild report warns of potential bubble valuations.
“The ongoing surge in US equity markets looks like it may have taken them too far from a valuation perspective, which have already priced in a stronger US economy and increased global growth,” which could hint at a pause in the equity markets, the letter noted. “Notably, there has been a strong revival of margin lending, which is now higher than in the 2000 equity bubble and approaching its previous peak even after adjusting for inflation. If this increase reflects positive investor sentiment then it could be an ominous sign for markets. That is because when investors use increasing amounts of leverage to enhance their returns, the market is often approaching its peak.”
Rothschild: Opportunity in Europe? Emerging markets? China?
While many hedge funds are noting opportunity in Europe as reported in ValueWalk, Rothschild is somewhat skeptical.
“European equities have outperformed on a relative basis recently. As a result, they have narrowed the valuation gap with other developed regions,” the report said. “Although conditions in the Eurozone have improved, the growth outlook remains weak, and France and Italy are struggling. Deflationary pressures owing to a strong euro could suppress any further outperformance. Although the Eurozone is recovering from recession, there are differences between individual countries. Notably, recent data for France was worse than expected but better for Germany and the region as a whole.”
Concerns across the EU regarding defaults and stimulus remain, according to the report. “One interpretation is that the ECB has not done enough to stimulate growth, and so it is likely to come under increasing pressure to weaken the euro. We are also concerned that the balance sheets of Eurozone banks are still shrinking. Although part of this is the result of fewer derivatives positions, less than a third of these balance sheets is being used to support the region’s real economy. In contrast, the ratio for the US is around half. Additionally, the provisions for non-performing loans have remained low, while corporate default rates have been rising and are now above average.”
Rothschild: Deflation concerns?
Many hedge fund investors watching the market for government debt express concerns regarding deflation, which is addressed in the Rothschild report. “Europe’s economy is facing a sluggish recovery and disinflationary trends. In response, the ECB cut rates in November. More action is likely from the central bank unless inflation picks up soon, which is unlikely given the strong euro, deleveraging banks, excess capacity and high unemployment.”
“While disinflation in the US could boost consumption if gasoline prices continue to fall, in Europe it is more likely to raise the spectre of deflation, or at least of a secular stagnation,” the report says. “The ECB could resort to further action and quantitative easing cannot be excluded.”
Rothschild: Credit market opportunities
Deflationary market environments may create certain opportunities in the credit markets, which the report touts. “A moderate economic recovery is positive for low-duration corporate bonds, which we believe offer a better risk reward profile than safe-haven sovereign debt. The spread tightening cycle is over in high-grade credit markets, however, and investors are collecting coupons, which do not always compensate for inflation or duration risk. Lower investment grade and short-term, better-quality high-yield debt offer more attractive risk-adjusted carry. Emerging market debt also offers selective higher-yielding opportunities.”
Rothschild: UK strength
On a regional basis, the report noted potential positives in Europe. “In the UK, the Chancellor’s Autumn Statement indicated an improved economic outlook, which should have favorable effects on fiscal projections. Spare capacity in the economy is likely to be eroded at a faster pace than expected, which should help the government to reach its goal to balance the cyclically adjusted budget over the next five years. The process of reducing the budget still has a long way to go and fiscal policy is likely to remain tight for a number of years, leaving only monetary policy to support the economy.”
The report contrasted opportunity in Europe with that of China and Japan. “In contrast, the yen has fallen further, which should boost the performance of Japan’s stock market in local currency terms.” China, a recent driver of economic growth, remains a different animal. “In China the direction of policy is the key ingredient for growth. The government is focusing on rebalancing the economy from a structural perspective, which should lead to a tighter liquidity situation. Although there remain concerns over a potential credit bubble, economic growth should be healthy. We expect a rate of more than 7% in 2014.”
Rothschild: Opportunities & threats
In conclusion, Dirk Wiedmann, Chief Investment Officer for Rothschild Wealth Management surmises opportunity exists in 2014, but that it may be selective.
“Our analysis suggests developed equities are the only asset class capable of delivering real returns in 2014,” the report says. “However, investor complacency, very positive sentiment and stretched valuations give us cause for concern that they could experience a period of consolidation. Additionally, the great rotation from bonds into equities is fully under way in the US and equity allocations are above the long-term average. On the other hand, this is not the case in Europe or in Japan where the process has yet to begin.”
Noting the opportunity, the Rothschild