Valuations continue to favour equities over bonds, says Threadneedle’s Mark Burgess

Mark Burgess, chief investment officer at Threadneedle Investments, says a review of assets over the past six months suggests equities continue to offer better value than bonds.

Tapering is not tightening but valuations continue to favour equities over bonds

At the start of the year, we forecast a challenging macroeconomic outlook for 2013, continued downside risks, and we expected interest rates to stay lower for longer. In terms of asset allocation, we were positive on equities relative to bonds on valuation grounds, and saw attractions in yielding assets. Within equities, we preferred Asia, emerging markets and the UK to Europe and the US.

In the first half of 2013, developed market equities have outperformed emerging markets, while fixed income has performed poorly, except for high yield bonds, which have benefited from their shorter duration characteristics. After a strong first quarter, risk assets rose through to mid-May before an aggressive bout of profit taking hit most financial markets. The trigger for this was the US Federal Reserve (Fed), which commented that it may ‘taper’ its bond purchase programme if economic data remains strong.

In this regard, the news is good for the US economy, but not so good for those who had expected quantitative easing (QE) to continue indefinitely. On the data front, US car sales have picked up markedly in the past two years and, importantly, housing starts have also improved – indeed, housebuilding is seeing a material uptick, having been a serious drag on the US economy over the past five years. As a result, US growth should continue to outperform the rest of the developed world. The fiscal cliff has also been less of a drag than feared, while the tax take has been better than expected.

The market now expects a US interest rate rise in 2015, about a year earlier than was forecast a few months ago and prior to the comments on ‘tapering’. It is worth emphasising that ‘tapering’ does not mean tightening (as shown in Figure 1 below), but rather making policy ‘less loose’. It is understandable that the Fed wants to begin to unwind QE, given the strength of the US economy compared to the rest of the developed world, and we expect this to happen in $20bn chunks, starting later in 2013. Further support for the ‘tapering’ argument comes from the fact that US inflation is very subdued, despite the pick up in economic growth.

Another important trend in the US is that manufacturing and employment are clearly on an improving trend. Unit labour costs are falling and have been for a while. The benefits to manufacturing of cheaper energy from shale gas are huge. Added to that, relatively high inflation in Asia from rising labour costs in that region is creating a shift in US manufacturing and its global competitiveness. As a result, new capacity is opening in the US and companies are repatriating some of their operations back to America.

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