The biggest threats to an equity bull market
21 February 2013
Henry Hunt, head of portfolio management at Thomas Miller Investment, says investors should not get complacent and points to the numerous headwinds that could undermine the gains made by markets this year.
Investor sentiment is much more optimistic and there is increasing talk of the "great rotation" from bonds to equities.
Some mega-deals have been announced in the corporate world, and there has been a remarkable absence of negative news so far in 2013.
Performance of indices in 2013
Source: FE Analytics
Overall, equities are still in a sweet spot; economic growth is picking up around the world – including the UK – but inflation is generally subdued and central banks are more interested in supporting growth with low interest rates and quantitative easing than in stifling inflation.
Secondly, valuations for equity markets are not particularly demanding at present and a further upward re-rating seems likely.
However, bullish investor sentiment has reached high levels, which is usually a negative signal.
Investors may have already made their move into equities this year and market momentum suggests that equity prices are a bit stretched.
The risk of a market setback is therefore quite high but given the other positive factors, investors should take advantage to increase exposure.
So what of the more fundamental risks that may lie ahead this year? Will there be a return of the bearish factors from last year – the euro crisis, the US fiscal cliff or a Chinese hard landing?
Will inflation become more of a problem again and lead to a tightening of monetary policy?
Or will private sector de-leveraging, higher taxes and excessive bank regulation drive the economies back into recession?
Finally, what of the growing geo-political risks, particularly in the Middle East and Asia, at a time when the US seems more inward-looking?
Thanks to Super Mario Draghi, the markets are not expecting another chapter of the euro crisis this year but it still seems the biggest risk.
Worries about both sovereign and bank solvency will persist, especially in the "Club Med" countries.
Monetary union remains dysfunctional as Germany seems to be getting stronger and the Club Med, including France, is getting weaker.
Euro break-up risks remain high as there is no end in sight as far as this divergence is concerned. Political risks have also re-surfaced recently in Italy and Spain.
As far as the inflation/deflation debate goes, UK inflation is likely to remain around 2 to 3 per cent for the next 12 to 18 months.
Worries about central bank money-printing are overdone at present because overall money growth is still quite modest.
Although oil and food prices could be a problem, underlying inflation will stay subdued while unemployment is still so high.
Once labour costs start to rise, however, corporate profit margins are likely to fall from record high levels. That is more a story for late 2014 or 2015.
The energy revolution in the US could cap energy prices worldwide but the green agenda is a longer-term risk in terms of higher prices.
Another major risk sometime in the next year or so will be an end to the QE policies that have been a powerful stimulant for asset markets.
The current bull market will probably continue – with inevitable setbacks from time to time – until the US Federal Reserve indicates a change in policy.
This may not happen until 2014 at the earliest as it has committed to keeping rates close to 0 per cent until unemployment has fallen to 6.5 per cent, compared with 7.9 per cent at present.
However, the markets may anticipate a change this year if US economic growth accelerates towards 2.5 to 3 per cent.
There has been a lot of talk in the last few years about the new normal of low growth and debt de-leveraging, but the current US economic recovery looks more like the old normal, with an expanding banking system, higher home prices and rising consumer confidence.
More important than the US fiscal cliff and debt ceiling negotiations are assets, especially house prices and the health of the banks.
Geo-political risks could hit equity prices this year, particularly if the Syrian or Iranian governments get into conflict with Israel, but these are likely to be only short-term setbacks.
Other than a major war, it is economic and company fundamentals that drive financial asset prices over the longer term.
In summary, while short-term setbacks are inevitable, the bull market in global equities has further to run this year and possibly next. After an 8 per cent gain already, the UK market is due for a pause.
In terms of overseas equities, we prefer US equities and the US dollar rather than the euro, as a return of the euro crisis remains the greatest risk.
Bond markets offer little value from a fundamental perspective, but will occasionally benefit from bouts of equity market volatility and risk aversion.
At the time of writing, the FTSE 100 has fallen 1.41 per cent today.
Henry Hunt is head of portfolio management at Thomas Miller Investment. The views expressed here are his own.
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