Developed Market Strength Persists - Market comment, LGT

Developed Market Strength Persists

The once much-feared "Fed taper" triggered strong and broad gains in developed equity markets - the US economy is finally seen as robust enough to eventually continue to grow even without its monetary crutches. On the other hand, the emerging markets have failed to rejoin the rally. Against this background, we decided to reduce emerging market equities and reallocate the proceeds to the US and European stock markets, as well as to Listed Private Equity.

Please find below the market comment by Mikio Kumada, Global Strategist from LGT Capital Management:

- Market comment (PDF)

- Foto Mikio Kumada (JPG)

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Developed Market Strength Persists

The once much-feared "Fed taper" triggered strong and broad gains in developed equity markets - the US economy is finally seen as robust enough to eventually continue to grow even without its monetary crutches. On the other hand, the emerging markets have failed to rejoin the rally. Against this background, we decided to reduce emerging market equities and reallocate the proceeds to the US and European stock markets, as well as to Listed Private Equity.

Tapering as a win-win situation

Almost exactly a month ago, on 18 December, the US Federal Reserve decided to start reducing its monthly purchases of long-term bonds. The timing and size of this so-called taper surprised us somewhat, but market reactions were broadly in line with our expectations. We had long suspected that the taper would likely prove a win-win situation for risk assets, because we thought the taper would either be taken as sign of a robust economy and strong investor sentiment, or not happen.

Mostly very positive market reactions

Market reactions across all asset classes clearly confirmed the trends of the past few years, which favor the developed markets. Western markets have rallied by between 3.3% (USA), and 6.4% (Eurozone, thanks to strong rallies in its periphery), followed by non-euro Europe with 5.2%, and Japan with 2.9% (for more, see page 2 in the PDF).

Emerging markets again fail to participate in the rally

By contrast, emerging markets have again failed to reconnect with this bull-run. The performance gap between the traditional developed regions (including Southern Europe) and the emerging markets (including many Asian economies) was the most pronounced market performance pattern since the Fed's December policy decision.

Developed markets have significant advantages

Among other reasons, developed markets at present share practical advantages from an investor's perspective - they are well-connected, open, diverse, and use liquid, fully convertible currencies. The highly accommodative central bank policies of the past few years can thus have a larger impact on these markets - not least because investors can easily hedge against potential side-effects, such as currency devaluation. In addition, earnings growth has been robust, more reliable, and consistently stronger than expected.

Emerging markets appear stuck in a lose-lose situation

The emerging markets, meanwhile, appear stuck in a lose-lose situation: with the taper "on," investors fear that capital might continue to be withdrawn from the emerging world. If taper were "off" - that could be bad too, as it would imply that the Western export markets remain in the doldrums. In fact, the emerging markets were underperforming even when quantitative easing was firing on all cylinders - they seem to lag no matter what. The persistent relative weakness in the emerging world certainly warns us that many of these countries are facing indigenous challenges of their own making - be it the potentially burdensome consequences of multi-year credit excesses, like in China, or underlying sociopolitical issues, like in Turkey or Thailand. These problems cannot be blamed on monetary policy decisions in the US or elsewhere.

Global industrial countries bull market intact

It is worth noting that, following a prolonged period of underperformance (since the fall of 2010 in China's case, for example), emerging market valuations have fallen to levels that suggest some of these potential problems are largely known and recognized by investors, which generally limits the downside potential. But valuations do not yet seem low enough to trigger a sustained EM rebound. Meanwhile, the developed market rally is likely to remain intact, underpinned by supportive policies and robust corporate earnings. We have thus decided to shift more of our tactical equity allocation in favor of the developed equity markets.

Pre-existing market regime confirmed with "Fed taper"
The chart (PDF page 2) shows the MSCI equity indices' net total returns in local currency since 18 December, when the Fed decided to cut its monthly purchases of government and mortgage-backed bonds by $10 billion to $75 billion. The reactions have confirmed the trends of the past few years. The developed economies, notably led by Southern Europe and Ireland, rallied. But most emerging and Asian markets underperformed or posted losses. In short: We are still dealing with a bull market that mainly favors the Western countries and Japan. It should also be noted that Greece was reclassified as an emerging market by MSCI last year, but we continue to show it as part of the Eurozone due to the consistency of its performance pattern since 2012 - Greece is obviously spearheading the euro periphery theme, while it would represent an exception in the emerging market universe.

Bonds and commodities: euro periphery on the upswing
Responses in the bond and commodity markets have also largely confirmed the pre-existing regime, favoring the traditional markets, rather than the EM and commodity themes. The "Fed taper" has also reaffirmed the stabilization in the euro periphery debt markets. It has not signaled an undue monetary tightening, moderately driving up gold and inflation-linked US government bonds. On the other hand, the small gain in inflation expectations is balanced by the continued decline in commodity prices as a whole. Markets thus continue to imply a rather benign economic environment in the developed regions, with decent growth, and not too much inflation. Note that for bonds, we show total return indices in local currency that represent a portfolio of all maturities.

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