Peter Lees, director of Equities at F&C has argued that there are reasons why investors can look away from sovereign bonds to equity again in the search for income.
Inflation on the rise
The consensus across most markets is that inflation is on the rise. The money pumped into economies globally through quantitative easing and other unconventional policies from monetary authorities indicates a willingness to see this happen in an effort to stimulate growth. This too plays into the hands of the equity investors as the real assets equities represent have the potential to perform and continue to deliver a ‘real’ return in such an environment, something traditional bonds will struggle to do.
As growth returns, which it surely will and interest rates start to rise to curb inflation, equities should still benefit. While this should also mean that the yield on fixed income stocks rises, it will come at a cost as capital values across the board will come under pressure. Is the frequency of high correlation events set to slow?
Recent years have seen a significant number of ‘high correlation’ events. Within this environment, driven by sentiment and central bank interference, company valuations move together, usually being more harshly punished for bad news than rewarded for good, irrespective of underlying fundamentals.
The strength of this correlation can be seen by looking at sectors within the FTSE All-Share Index. The chart below shows the performance of the Industrial Engineering and Forestry & Paper sectors over the last three years with a correlation figure of 0.7 (1 represents perfect correlation and 0 no correlation). This second chart below compares the performance of the Beverages sector with that of Software & Computer Services and while on the one hand they appear quite different, the scale can be misleading as they have a correlation figure of 0.64.
While we are not yet out of the woods as regards such events, I do believe we are on the path to more ‘normal’ markets. This means I would expect conditions where correlations remain lower and stable, with fundamentals the key driver of returns, rather than macro influences and should ultimately be rewarded. Our defence against rising correlations and sentiment-driven events is to hold good quality companies that will ultimately benefit from strong company management and positive cash flow and the subsequent reward in positive absolute and relative share price movements.
Equity markets are reasonably valued following the recovery we have seen in the closing months of 2012 and at the start of 2013, not cheap but by no means expensive. The yield delivered by equities should also mean an underpinning to values as investors and asset allocators look for an attractive and reliable income stream over the long-term, something high quality sovereign debt is unable to do at present and seems unlikely to be able to do for some time.
As we continue to work our way through the uncertainty, be it political, economic or regulatory, greater clarity should emerge. As we approach this seeming nirvana I believe we will enter a period that witnesses a clear asset shift away from bonds into equities and one where performance is driven by stock-picking rather than the big macro picture.