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Observant investors will have noticed European equities roaring ahead of the US of late, enjoying their best six months versus the S&P 500 in almost a decade, powered by an earnings revival and an improving economic picture. Not to be outdone, emerging markets are also among the biggest winners so far this year, up 11 per cent.
Is the optimism justified? Certainly markets are seeing buoyant survey data, rising consumer confidence and improving trade activity across the world. But how about the character of the markets themselves? Looking beyond the surface, there are signs that market participants judge the global economy to be on safer ground than at any time since the recession. That should give those fretting about expensive valuations reassurance to stay invested.
After the crisis, stock prices of companies bounced around in near unison, instead of diverging according to their own merits. At the same time, investors were swinging between hope that the recovery was progressing and fear that a relapse was around the corner. This “risk-on, risk off” behaviour characterised investing for so long that nearly everyone forgot it wasn’t a permanent, intrinsic feature — until recently.
In the latter half of 2016, stocks started to move more independently of one another and the dispersion of sector returns (how differently each sector performs relative to the others) also rose. Some sectors surged: financials were boosted by interest rate rises and hopes of deregulation in the US; energy and materials stocks rose as commodity prices continued to recover.
This movement within stock markets has not been apparent at the index level. In the first quarter of a year there are on average 18 days in which the S&P 500 moves more than 1 per cent. In the same period this year, such movements occurred on only two days.
So how does the churn beneath the surface tally with greater confidence in the economic outlook among investors? The fall in correlations suggests we may have entered a new investing regime where individuals are less concerned about macroeconomic instability and more interested in company-specific factors.
The reasons for less economic worry are clear. The global economy is not just out of the emergency room: we left the hospital a while ago and just handed back our crutches.
After the crisis, a gap opened up between where the economy was and where it could be if operating at potential. Almost eight years later, that gap is greatly reduced. Around a quarter of developed economies now have little or no spare capacity: that is a great improvement from 2009 when nearly all had spare capacity. However, there is scope for further growth.
More tangibly, more than half of developed countries are at full employment and financial systems have recovered significantly, boosting the growth of credit in all leading economies.
The good news extends to emerging markets. A year ago there were signs of worry here as currencies continued to fall alongside commodity prices. But with falls in both now convincingly over, growth improving and valuations modestly below average, emerging markets are both participating in global growth and leading the equity market rally.
This means investors are no longer in thrall to every word uttered by central bankers. Recent increases in policy rates in the US and talk of tapering bond purchases both there and in Europe, which only recently would have prompted tantrums among investors, have instead been greeted positively.
It is not clear the pattern will persist. Big sector movements have been instrumental in the correlation breakdown we saw. As the surge in those sectors abates, correlations may rise again. But if they do not, the practical implications for investors are two-fold.
First, investors shouldn’t write off active management just yet. The post-crisis era of high correlations between stocks has made the job of selecting winning stocks harder, and many managers have struggled. With greater differentiation among stocks, active managers could have more opportunities to shine.
Second, if we are only now at the point where the recovery can be trusted, it’s a good bet we have a way to go before the cycle ends. There is scope for growth in many economies, both rich and poor. Yet many UK investors are not exposed enough to that growth. The UK stock market represents just 6 per cent of the global equity world, but allocations in most British portfolios are a multiple of that figure.
Market signs are telling UK investors that the opportunity remains for diversification into the growing world beyond our borders.
The author is a global market strategist at JPMorgan Asset Management. Twitter: @JPMAM_UKAdviser
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