International outlook

Global equity markets posted good returns in the second quarter, with a gain of 5.1% for the MSCI World Index (MSCI World) and 6.7% for the MSCI Emerging Markets Index (MSCI EM). That brings the year-to-date (YTD) performance of the indices to 6.5% and 6.3% respectively. It must be noted that, in the process of generating these returns, the US equity market actually achieved 16 record closes in the second quarter, and marked its sixth consecutive quarterly gain. The S&P 500 index ended the quarter after not closing up or down more than 1%, for 51 trading days in a row; the longest such stretch since 1995. And in late June, the CBOE Volatility Index (VIX) hit its lowest level since 2007. The VIX finished the quarter at 11.57, down from 13.88 at the end of March. To give this context, the VIX was at 21 earlier in 2014, and touched 75 during the 2008 crisis.

It is also worth highlighting that the MSCI EM has now gained 14% from its recent low in February. The recent outperformance of emerging markets (EM) appears to reflect several factors, including speculation that Chinese authorities will adopt stimulus measures, an apparent de-escalation of tensions between Russia and Ukraine, and optimism that the election success of India’s probusiness BJP party will boost that nation’s long-term growth prospects.

Additionally, commodities such as gold, oil and nickel also enjoyed strong runs in the first half of 2014. The gold price rose by 2.1% for the quarter (9.0% YTD), oil by 7.3% (2.3% YTD) and nickel by 19.6% (37.1% YTD). The price of iron ore was the biggest surprise on the downside – falling by 32% since the start of 2014. This reflects the impact of the slowdown in the unprecedented Chinese infrastructure boom over the past decade.

Gains in global equity markets this year came despite rising concerns about potential deflationary trends in China and Europe, along with disappointing growth numbers from the US during the first quarter of this year. This threat of deflation has been reflected in strong rallies in global bond markets, with the bellwether US 10-year Treasury yield falling from 3.0% at the beginning of the year to around 2.5% by the end of June. Corporate bonds also performed well, with the Barclays US Aggregate index gaining 1.95% during the quarter. The Barclays US Corporate High Yield index rose 2.4%, as it flirted with the record low of below 5% set in May 2013.

The same low-growth concerns drove gains in the defensive sectors of equity markets, particularly utilities, health care and consumer staples in the MSCI All Country World Index (MSCI ACWI). That said, cyclical sectors, including energy and information technology, have also outperformed the MSCI ACWI this year, suggesting that investors continue to believe that global growth will be reasonably positive. Against this low-growth and therefore low-rate backdrop, some of the best-performing parts of the market have been those offering big dividend payouts, as investors hunt for more income than can be found via many bonds. During the quarter, real estate investment trusts (REITs) were a prime beneficiary, with the MSCI US REIT Index rising 7.2% for the quarter, including dividends.

In essence, the second quarter, indeed the first half of 2014, has continued the unpredictable pattern we have experienced since the dramatic events of the credit crisis and the subsequent deleveraging. While investors are generally cognisant of the inevitable dislocation caused by these events, few can actually fathom what the long-term consequences will be. The deleveraging and the subsequent massive injections of liquidity by the US central bank have ensured that the present period has no precedent in terms of ‘what the text books tell us’. Take for example the fact that, as referred to before, global stock markets and bond prices actually rose in unison between January and June, for the first time in 20 years. This synchronised rise has been described by many commentators as ‘rare’ and ‘puzzling’ and prompted warnings about a potential market crash as bonds and stocks tend to move in opposite directions. Such commentators will fall back on conventional wisdom, pointing out that such an anomaly can’t be sustained and that the benign environment for risky assets and bonds probably won’t continue for the rest of the year. The point, however, is this: we are not living in ‘conventional’ times.

One of the other key themes of the first half of 2014 was the worldwide surge in mergers and acquisitions (M&A). The final quantum of M&A activity was $2.2 trillion according to Bloomberg, an increase of 77% year-on-year (YoY). Europe (+109% YoY) led the way with a massive resurgence in corporate activity, though this was off a low base. North America followed closely, with an increase of 79%. In terms of industry, the biggest increases were in the pharmaceutical sector (+677%) and in healthcare (+140%). Not surprisingly, one reason for the surge in M&A has been the accommodative capital markets. An example of this was a jumbo bond deal from Oracle, which placed $10bn in bonds (the second largest US dollar offering in the year to date) to fund the purchase of Micros Systems.

Equity markets seem to disregard any risk of a US recession even as that economy contracted by a surprisingly large annual rate of 2.9% in the first quarter of 2014. This is primarily because the poor GDP data are at odds with other indicators – including sharply improving employment numbers, buoyant business surveys, as well as robust manufacturing and durable goods numbers. Also, the contraction was in large part due to extremely harsh winter weather and major cutbacks on healthcare spending by corporates following the commencement of ‘Obamacare’. Companies terminated the healthcare insurance provided to the many part-time workers who opted to take advantage of state-funded cover. Given that the two main reasons for the contraction are anomalous, it appears likely that US growth will recover to a range of between 4% and 4.5% in the second quarter before settling back to between 3% and 3.5% in the second half of this year. If this turns out to be correct, then US bond yields could well experience renewed upward pressure in the second half of this year as investors refocus on the potential timing of the Fed’s exit from supereasy monetary policy in 2015. In the meantime, however, the decline in US bond yields triggered a renewed ‘stretch for yield’ in global fixed income markets. That has been a major plus for EM currencies and capital flows to the so-called ‘fragile five’ nations of Brazil, India, Indonesia, Turkey and South Africa, whose equity markets have all outperformed the MSCI EM so far this year.

Strengthening the ‘stretch for yield’ theme in global markets is the likelihood of further modest easing by the European Central Bank (ECB), which has seen euro-area inflation fall to well under 1% this year. It remains to be seen how extensive the expected easing will be, but the ECB will remain under pressure to unveil measures to boost bank lending from current anaemic levels. In contrast, expectations for further easing from the Bank of Japan have faded as officials there seem confident that they will meet their inflation target of 2% in fiscal year 2015. The other major wild card for the global outlook remains China, which reported disappointing annualised growth of only 5.9% in the first quarter as property markets and housing investment sagged. Many economists expect some improvement in sequential growth over the next few quarters as government stimulus efforts kick in and the global economy improves. That said, prospects for long-term growth in China remain clouded by the prospects of multi-year deleveraging and the reduction of excess capacity.

Looking at the future, the critical assumptions here are that real yields won’t need to move a lot higher and that the spread between equity and bond yields won’t be much greater than normal. We do expect government bond yields to move higher as the recovery progresses, somewhat faster than the consensus forecasts are currently suggesting. But we think equity valuations offer sufficient cushioning – as long as that move is not too large or too rapid. If that assumption is wrong and the real rate of return that investors require to hold government bonds rises much more sharply, then investors may require higher anticipated returns in equities than current valuations are offering.

History also clearly shows a risk that equity valuations could fall even without a shift in bond markets. This happened during the Wall Street Crash of 1929, the tech bubble collapse in 2001 and the global financial crisis of 2008/09. But these slumps came against the backdrop of either deep economic collapse or massive overvaluation. And while the current (high) price earnings ratios were last seen during the equity bubble of the late 1990s, at that time the spread of earnings yields to real bond yields was negative. The position today is quite different: the spread now favours equities. It is of course possible that other concerns – including that the failure to generate growth will lead to ‘Japanisation’ (deflation and zero interest rates) or that bond yields may move sharply higher – may unnerve investor confidence, which remains deeply scarred by the global financial crisis. This will push the risk premium on equities higher than the current level. But this is not our expectation, as we believe that volatility should remain low for some time.

It must be highlighted that persisting above-average equity valuations will have potentially negative consequences. This is an argument that future returns will be much lower than the historical average, for equities as well as bonds. And if equities continued to gain beyond our forecast of the next one to two years, it will imply even lower return prospects over the medium term. Will this benign state of affairs require a significant correction to restore much higher expected returns? Or will there be a continued shift towards acceptance of low returns? Ultimately, a world of low financial returns may bring its own set of problems. This environment does, however, look a lot like the world we currently live in.

In summary, the global economy and equity markets represent a mixed picture. On balance, volatility has remained low and investors appear relaxed about global growth prospects. Equities remain attractive relative to fixed income, with the MSCI World and MSCI EM trading at forward price earnings ratios of 15.0 and 10.2 respectively, while government bond yields remain painfully low. We also continue to believe that cyclical equity sectors generally offer a better risk-reward trade-off than highly defensive sectors, particularly following the outperformance of the latter earlier this year. Despite the very poor US GDP numbers, our market and economic views have not changed much over recent months. We view the US equity market as attractive relative to bonds but fairly valued on a standalone basis. The global economy appears to have bottomed out, while the US economy looks to be accelerating. The US Fed is laying the groundwork for normalised monetary policy but is acting slowly, while the ECB continues to ease. In the US, both state and federal deficit trends are positive and seem under control. At a minimum, this should reduce restrictive fiscal policy and ultimately add some stimulatory impact. Overall it seems to be a pretty benign environment with a bias towards economic acceleration. Persistently low inflation, high underemployment, and an output gap give monetary authorities at least the perception that they have room to react if current policy turns out to be too loose

Modern developed economies are, it must be repeated, in uncharted territory. They are emerging from a financial crisis with interest rates well below any reasonable estimate of long-term equilibrium levels. It is hard to predict with confidence how the market will react to rising interest rates.

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The Allan Gray-Orbis Global Equity Feeder Fund remains fully invested in global equities. The objective of the Fund is to outperform the FTSE World Index at no greater-than average risk of loss in its sector.