Sentiment appears to have plunged in recent weeks with major equity indices sliding further and further, volatility spiking and hints from the notes of the Federal Reserve’s Federal Open Markets Committee that the US dollar’s recent strength could derail global growth.
According to FE Analytics, investors have reacted by pulling money from equity markets in the past few weeks with the MSCI World more than halfway towards a 10 per cent correction – although it is still up since the beginning of 2014.
Performance of index in 2014
Source: FE Analytics
Flanders says the strength of the dollar is of particular concern to investors.
"Every conversation I have had with senior fund managers and economists over the past few days has been dominated by talk of the strong dollar. The US is becoming more self-sufficient on the trade front at a very inconvenient time for the rest of the world,” she said.
“With so many countries looking abroad for demand to drive their recoveries, it's hard to avoid the conclusion that the dollar is going to keep going up against most major currencies. Periods of dollar strength have often been bumpy ones in international markets."
She says this has meant valuations are no longer cheap and that for especially income-hungry investors, diversification is increasingly important.
Since markets bottomed out in April five years ago developed equity markets have seen strong multiple expansions.
This was led by the S&P 500, which hasn’t corrected more than 10 per cent for over three years when markets had their last significant upset as fear gathered over the eurozone sovereign debt crisis.
Performance of developed market indices since Apr 2009
Source: FE Analytics
Flanders says the main developed markets are no longer cheap despite recent falls but look reasonably priced, particularly in comparison to traditional fixed income.
“In the US, we see diminishing scope for multiple expansion or rising profit margins to contribute to investor returns in the next year or two, but growth in corporate earnings should continue to deliver moderate returns.”
She says as a result investors, particularly those reliant on income, should diversify holdings to include emerging markets.
“Diversification is also a key theme for investors in the search for income, because the search is not getting any easier.”
“With dividend yields in major equity markets still at attractive levels, sourcing income through equities is a way to enhance and smooth returns in this low yield environment. Indeed, in the UK, it is striking that the benchmark corporate bond yield is now extremely close to the dividend yield for the FTSE 100,” the strategist said.
“However, investors should be mindful of valuations, as some high-yielding sectors and stocks have become stretched. This is another area where valuations in emerging markets look more compelling.”
But she adds that equities remain the most attractive asset class partly due to accommodative monetary policy but also to the dearth of opportunity in fixed income.
“The bottom line is that this is still a world that rewards risk takers: an overweight in equities and other risk assets makes sense as long as all of the main central banks are looking for more growth and higher inflation than the world economy seems able to deliver.”
However, Flanders says this is less the case in the eurozone where, despite a commitment to do “whatever it takes” to preserve the euro from president of the European Central Bank Mario Draghi, there remains weakness at a national level.
“The eurozone is approaching a critical period – both economically and politically. Weakening activity and the continued low level of inflation has heightened investors’ expectations that the European Central bank will act to support growth.”
She says this has helped push down the value of the euro, which should support corporate earnings in the next few months, but adds that severe problems among member states show no sign of abating quickly, which is the impetus markets need to re-rate.
“We need to see improvement on all these fronts in the coming months to feel confident in the strength of Europe’s recovery. The ECB has always said it couldn't fix the eurozone on its own - the difference now it that investors have finally decided to believe it.”
“There is now so much pessimism around, there is scope for a change in sentiment around the turn of the year as the weakening of the euro starts to feed through to corporate earnings and the review of European bank balance sheets lifts the question mark hanging over the financial system - but governments need to do their bit to make that happen.”
