Markets near all time highs - Is it time to take profits?

by Gavin Graham, Chief Strategy Officer April 16, 2014
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The first quarter of 2014 saw bond and stock markets stumble, then recover. Worries over tightening by the US authorities, triggered a sharp fall in the markets worldwide in January and February. This was mainly due to the new Chairperson of the US Federal Reserve (the Fed), Janet Yellen, reiterating her predecessor Ben Bernanke's determination to keep reducing the amount of government and mortgage backed bonds that the Fed would buy throughout 2014.

Interestingly, while indexes in the major economies such as the S&P500, Japanese Nikkei225 and the Euro Stoxx50 all sold off by 5% or so, emerging markets, as represented by the MSCI Emerging Markets Index, were hit much harder, with falls of 8-9%, exacerbated by sharply weaker currencies, with such countries as India and Turkey seeing the rupee and lira hitting record lows against the US dollar. What had become known as the “Fragile Five”, which consisted of major developing countries like Brazil, India, Indonesia, South Africa and Turkey with large current account deficits all had to raise interest rates to try to slow down their economies and reduce imports as foreign investors pulled their capital out in response to tighter monetary policies, known as “tapering”, by the Fed.

Even the Chinese currency, the renminbi, which had been steadily appreciating against most major currencies over the last decade, saw a widening of its trading range in February and promptly weakened by between 2-3%, discomforting many investors who had been borrowing cheap US dollars to swap into renminbi as a bet on its continued appreciation.

Interestingly, however, March saw a recovery not only in developed stock markets, with the S&P500 rebounding to now be up 1.4% so far in 2014, but also in the vulnerable emerging markets. The MSCI Emerging Markets Index rose 2.9% in March in US dollar terms, leaving it down only 0.8% year to date against an increase of 0.8% for the MSCI World index of developed markets. Of course, over the year ending 31st March, 2014, the MSCI World Index has performed much better than the MSCI Emerging Markets Index, up 16.7% against a fall of 3.9%, and over the last 3 years has delivered annual returns of 7.8% per annum against losses of 5.4% p.a.

Bonds have also been hit by the tapering policies of the Fed, with the yield on the benchmark 10 year US Treasury seeing its yield rise 1% to 2.7% over the last year, and the Bloomberg US Treasury Bond Index returning -2.2% over the same period, after including interest. Usually, rising bond yields and the prospect of monetary tightening are not good news for stock markets, and when an investor finds that most of the rise in such indexes as the S&P500 and the Eurostoxx50 over the last year has come from higher valuations (rising Price/Earnings ratios) rather than from growth in earnings by the companies that make up the indexes, they may decide it is time to become more cautious and take some profits on their developed market stocks.

In the market outlook that I prepared for BNN and the Globe and Mail when I last appeared in March, I suggested that Canadian investors might look at reducing their non-Canadian equity exposure by 15-20%, as markets such as the US, Europe and Japan had all risen by around that amount, even before taking the falling Canadian dollar into account, which would have increased the returns to Canadian investors by another 10-15%. This compared with a modest rise of only 8% for the S&P/TSX Composite, held back by gold and natural resource stocks, which had been bad performers due to slowing economic growth in the emerging markets.

Thus to rebalance equity weighting in balanced accounts to the asset allocation that they felt appropriate at the beginning of 2013, investors need to reduce non -Canadian developed market exposure and reinvest the proceeds in Canadian and emerging markets. Unless fund trustees and investment committees feel that there has been a fundamental change in the economic outlook for developed markets versus emerging and frontier markets, then the better demography and higher growth rates in the latter should ensure that their markets eliminate their under performance against developed stock markets over the last few years. Whether this occurs through a better performance from emerging stocks or a decline in developed markets is not clear at present, but the continued rise in long term interest rates in the US and Europe now that Quantitative Easing has stopped would point to the latter being more likely.

Source: Bloomberg.com current as of April 6th, 2014