Observant investors will have noticed European equities roaring ahead of the US of late, enjoying their best six months versus the S&P 500 in nearly a decade, powered by an earnings revival and synchronised economic improvement. Not to be outdone, emerging markets are also among the biggest winners so far this year, up some 11 per cent.
Is the global optimism justified? Certainly markets are seeing buoyant survey data, rising consumer confidence and improving trade activity across the world, but how about the character of the markets themselves?
Looking beyond the surface, there are some signs that market participants now judge the global economy to be on safer ground than at any time since the great recession. That should give investors fretting about admittedly expensive valuations some reassurance to stay invested.
During the post-crisis period, the stock prices of different companies bounced around together in near unison, instead of diverging based on their own merits. At the same time, investors were swinging between hope that the recovery was progressing well, and fear that a relapse was around the corner. This “risk-on, risk off” behaviour characterised the investing landscape for so long that nearly everyone forgot that it wasn’t a permanent, intrinsic feature – until recently.
In the latter half of 2016, stocks started to move more independently of one another, and the dispersion of sector returns (how differently each sector was performing relative to others) also rose. This phenomenon has primarily been driven by certain sectors surging higher, such as financials, in light of interest rate hikes and hopes of deregulation in the US, and energy and materials stocks, as commodity prices continued their recovery.
Counterintuitively, this movement within stock markets has led to a period of notable calm at the index level. While the first quarter of a year tends to experience an average of 18 days in which the S&P 500 moves up or down by more than 1 per cent, the same period this year saw only two days where such movements occurred.
So far, so interesting. But how does the churn under the surface tally with greater confidence in the economic outlook among investors? The fall in correlations suggests we may have entered a new investing regime where investors are less concerned about macroeconomic instability, and more interested in company-specific factors when making an investment.
Closing the gaps
In the aftermath of the crisis, a massive gap opened up between where the economy was and where it could be if operating at potential. Almost eight years later, that gap is greatly reduced. Around a quarter of all developed economies now have little or no spare capacity. That is up from close to zero in 2009 but with scope for further growth. More tangibly, over half of developed countries are at full employment and financial systems have recovered significantly, facilitating positive credit growth in all major economies.
This good news extends to emerging markets. A year ago, there was a sign of worry as currencies continued to fall alongside commodity prices and trading volumes. But with the downdraft in both now convincingly over, growth dynamics improving and valuations still modestly below average, emerging markets are both participating in the global growth story and leading the equity market rally.
This progress means that investors are no longer in thrall to every word uttered from central bankers. Indeed, recent increases in policy rates in the US and talk of tapering bond purchases both there and in Europe, which only recently would have prompted tantrums among investors, have instead been greeted positively by markets.
Too close to home
It is not clear at this point whether this pattern will persist in coming quarters. The big sector movements have been crucial in the correlation breakdown we have witnessed and as the surge in those sectors abates, correlations may rise again. But if the recent pattern continues, the practical implications for investors are twofold. First, they shouldn’t write off active management just yet. With greater differentiation now evident at the stock level, active managers could have a greater opportunity set than before, and value investing may well be more rewarded than in the recent past.
Second, if we are only now at the point where the recovery can be trusted, it’s a good bet that we have a way to go before the cycle ends. There is clear scope for further growth in many economies, both rich and poor.
Yet too often UK investors are not exposed enough to that growth. The UK stock market represents just six per cent of the global equity world, but allocations in most British portfolios are a multiple of that figure. Market signs are telling UK investors that the opportunity remains for diversification into the growing world beyond our borders.