28th April 2011

F&C: Markets poised for a breakout?

Equity markets continue to be resilient in face of much negative news in recent weeks. The main events have been political uprisings in the Middle East North Africa (MENA), the Japanese earthquake and the continuing concerns about imminent default in the Eurozone periphery. More recently, S&P has drawn attention to the fragility of the US economy and size of its fiscal deficit by downgrading the outlook on its debt, although it retains its AAA rated status. Against this backdrop, the oil price continues to rise relentlessly, a de facto tax on consumers and business alike, and in the developed world the turn in the interest rate cycle has arrived with the ECB raising rates earlier this month. Meanwhile in the emerging economies, inflation continues to surprise on the upside and many countries have been forced into various measures of monetary tightening, including aggressive interest rate rises.

Why then have markets been going up? As a journalist in the Sunday Telegraph at the weekend said ‘’has the world gone completely mad?’’. No, it has not but he is a very stale bear. The point is that the factors that have driven the current bull market are still intact and in many cases are improving. The main ones are as follows:

• Modest valuations for equities and attractive against other asset classes, especially bonds
• A global economic recovery including the world’s most important economy, the US, growing at a reasonable pace. Crucially, the recovery in the US has recently broadened to include job creation. The sharply upwardly pointing shape of the yield curve in the US is suggestive of further recovery and although the yield curves of EM are much flatter the concern there is of too much growth not too little while inflation is rising.
• A much stronger recovery in company earnings than GDP growth would suggest. This is continuing, surprisingly, in the current earnings season with earnings beats still comfortably outpacing misses at a time in the cycle when we have usually reached or gone beyond the inflexion point in earnings revisions.
• Companies, unlike governments and the private sector, are flush with cash and relatively under geared. With investors seeking to avoid debt this is an attractive calling card.
• The M&A cycle is still picking up. Witness the deal by Johnson & Johnson earlier this week as a recent example.
• Deflation has been all but defeated. Bernanke may not admit it but the aggressive monetary policy of world central banks, especially the Federal Reserve, has created an upside risk for inflation now. The bond markets are beginning to factor this in and the gold price has broken out to new highs in the last month, partly reflecting this risk. Equities, as a real asset, are also an excellent hedge against inflation.
• The scramble for yield goes on in a low return and inflationary environment. Low investment grade bonds have already benefited from this and look vulnerable to a correction and with ‘safer’ corporate and government bonds offering low yields, equities are an attractive alternative, especially as dividends are rising strongly again.
• Several brokers have tried to call the top of the market or become more defensive. There is still quite a lot of scepticism and bearish sentiment around that is not consistent with the top of a bull market.

Thus, we believe the fundamentals are sound for equities despite the magnitude and duration of the current bull market. The global strategy team remains constructive on equities and expects at least one more leg of the bull market. The timing of this note reflects the fact that the S&P and FTSE All-Share Index are poised to break to new highs in the current bull market that could trigger a strong run. I am not a technical enthusiast but the chart for the FTSE All-Share below shows a strongly inverted head and shoulders. We have flirted with the old high on several occasions and if we break through decisively soon, as I expect, the next resistance would be the all time high of mid 2007.

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