Market View - May 2012

"Sell in May and go away, don’t come back until St Leger Day!" is a powerful City and Wall Street adage that has worked surprisingly consistently over the decades according to various research.

However there are of course many years when it doesn’t work and would have proved costly to investment portfolios to have adhered to. This almost certainly would have been the case in the fourth year of an US presidential election cycle for fairly obvious reasons!

Additionally the question on most market commentator’s lips currently is “Will the Federal Reserve twist again or stick, when the current 'Operation Twist' comes to an end on June 30th?” Announced on the 21st September 2011, Operation Twist involved selling $400 billion in short term Treasuries in order to buy longer term securities, thereby reducing longer term rates.

Since long term rates have remained low (with for example the 10 year Treasury yield at around 1.95% currently after hitting an historic low of 1.72% last autumn ), the strategy has arguably been successful. Opinion is however split as to whether further accommodative easing is required with two prominent regional fed presidents (San Francisco’s John Williams and Dallas’ Richard Fisher) arguing against it this week.

Meanwhile closer to home, two important elections will take place in May that will help determine the future outlook for Euro zone sovereign debt issues as both France and Greece go to the polls. Once the results are in, global economic policy makers and the markets will have a better idea as to whether the current approach to addressing the debt issues on the continent is likely to continue being endorsed by the electorate!

The good news is that the risks of a break-up of the euro-zone look to be already priced in to valuations. A Bloomberg poll of global investors in January showed that 59% of investors thought that one or more countries would leave the euro by 2016. Arguably this is why European equities on criteria such as price to book and price to cyclically adjusted earnings look cheap versus both history and other markets.

April saw most global equity markets reverse March’s gains with the MSCI World in $ terms falling 1.37%, with the FTSE 100 down 0.53%, the FTSE Eurotop 100 down 2.42%, MSCI India falling 1.46% and even the S&P 500 in the US falling 0.75%. The Chinese market was the big exception as the Hang Seng in Hong Kong climbed 2.62% and the Shanghai Composite rose 5.90%, while the global bond bull market (that supposedly is always ending!) resumed as the JPM Global Bond index rose 1.60%.

While most major equity indices fell during April, the returns since the start of 2012 still look extremely good with the FSTE Eurotop 100 up 2.49%, the UK’s FTSE 100 up 2.97%, the Shanghai Composite up 8.95%, the S&P 500 up 11.16%, MSCI India up 13.25%, the Hang Seng up 14.43%! In $ terms the MSCI World equity index is 9.42% since the 1st January while the JPM Global Bond index is up 0.67%.

Looking at these returns, investors could be forgiven for thinking that consolidating some or all of them through switching to lower risk asset classes (i.e. selling in May) could be sensible, but with the Federal Reserve in the US and other major central banks continuing their ZIRP (zero interest rate policies) together with other variations of quantitative easing (Operation Twist being one), the risk return trade off has become asymmetrical and on a relative basis, arguably equities are the most attractive asset class in the short to medium term. Longer term it is more difficult to discern the impact these measures will have on equity markets and whether the low of March 2009 was the end of a secular bear market and the beginning of a new secular bull?

Opinion on the performance of the Federal Reserve as it approaches its centenary in 2013 remains divided with James Grant a renowned critic being most vociferous of its handling of monetary policy and when he attended a lunch at the Federal Reserve Bank of New York recently he penned his remarks in a piece titled “Piece of My Mind”. Some of Grant’s key remarks included “As you prepare to mark the Fed’s centenary, may I urge you to reflect on just how far you have wandered from the intentions of the founders?”

“The institution they envisioned would operate passively, through the discount window. It would not create credit but rather liquefy the existing stock of credit by turning good quality commercials into cash – temporarily. This it would do according to the demands of the seasons and the cycle. The Fed would respond to the community, not try to anticipate or lead it. It would not override the price mechanism – as today’s Fed seems to do at every available opportunity – but yield to it.”

Grant’s remarks include a recommendation to the Fed to read Lew Lehrman’s book “The True Gold Standard: A Monetary Reform Plan without Official Reserve Currencies: How We Get from Here to There” and concludes by saying what he would do if he were Chairman of the Fed, including normalising interest rates, while ignoring deflation phobia and moving back to a more capitalist stance. Additionally James would abandon all the “Bayesian analysis of stochastic volatility models with Levy Jumps: Application to Risk Analysis”, introduce a Gold Standard for the 21st century and “finally my piece de resistance, I would commission, staff and ceremonially open the Fed’s first Office of Unintended Consequences”

Doubtless the debates and arguments on the best way forward for both the global economy and markets will rage for some time yet, but for investment portfolios equities currently continue to offer the best risk adjusted potential for real (inflation adjusted returns)!