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As investors prepare for summer, the heat is already on equity markets.
Global stocks turned negative for the year in May and on Thursday the FTSE All World index declined more than 9 per cent over the month. Among the hardest hit markets during May have been Spain, down 13.1 per cent and Italy, off 12 per cent. The losses are greater in dollar terms.
The flagging performance reflects a profound lack of conviction among investors about a near-term resolution of eurozone debt problems. Investors have flocked to the havens of core government bonds, sending benchmark yields in Germany, the UK and US sliding to historic lows this week.
Equities now look even more attractive when compared with the meagre yields of haven bonds. Yet investors remain wary of stocks given the volatile macro backdrop.
Policy makers have yet to convince markets that they have the will and means to stop the eurozone crisis from escalating to the point where a country leaves the single currency area. Attention is also focused on China not disappointing consensus forecasts of 8 per cent growth as fears also grow on whether the US economy can resist further slowing, with the May employment report on Friday the next major event for investors.
“The market is looking for a resolution in the eurozone and wants to see signs of re-acceleration in stable economies, led by the US and China,” says Andrew Root, US head of equity research at Macquarie Group.
Such uncertainty leaves investors weighing the potential for either a powerful rebound in risk appetite or further selling of equities this summer.
“The news-driven nature of this gyrating global equity market may only be one or two headlines away from renewed risk-on or increased risk-off,” says Sam Stovall, chief equity strategist at S&P Capital IQ.
May was certainly a risk-off month. Asian stocks are down more than 10 per cent over the past month, with losses even greater in US dollar terms. In a classic scramble for safety, the dollar has surged against most Asian currencies as well as the euro in recent weeks.
On the Chinese mainland, where equities are cut off from international capital flows, the Shanghai Composite is little changed on the month although it has spent the year bumping along close to three-year lows.
But, amid the broad sell-off in May, two markets – the German Dax and the S&P 500 – have been more resilient. Despite hefty losses during May, they remain up 6.2 per cent and 4.2 per cent respectively for the year.
In the US, the S&P has benefited from haven flows.
“In a world of “black and white,” US assets have clearly enjoyed the spotlight even as most other countries’ stock markets slowly fade to at least a very deep grey,” says Nicholas Colas, chief market strategist at ConvergEx Group.
Over the month, as the S&P posted a slide of 8 per cent from above 1,400 to under 1,300 before bouncing modestly, high yielding and defensive telecom, utilities and consumer staples outperformed the benchmark.
Not surprisingly, energy, financials, materials, technology and industrials have all fallen more than the benchmark’s overall slide of 6.3 per cent.
For some, the divergence between equities and bonds is now overdone given no recession for the US economy – albeit with slow growth – and expectations of S&P earnings rising to a record $105.44 a share in 2012.
“The combination of the rising equity risk premium, falling stock prices, improving corporate earnings and lower Treasury yields means that stocks have become quite cheap relative to bonds,” says Bob Doll, chief equity strategist at BlackRock.
The S&P is priced at 13.2 times earnings and has a dividend yield of 2.2 per cent, well above the record low 10-year Treasury yield of less than 1.54 per cent.
Jack Ablin, chief investment officer at Harris Private Bank, says that the low level of bond yields implies earnings growth for the S&P 500 will turn sharply negative this year.
“Somebody will be right and there is a huge valuation differential between equities and bonds,” he says.
“Ultimately, fundamentals win and we still see the US economy growing at 2 per cent, plus or minus a quarter point this year, which makes the US market sub-trend, but resilient,” predicts Macquarie’s Mr Root.
But much still depends on the response of eurozone policy makers.
“With valuations already suggesting that stocks are very cheap relative to bonds, a compromise in Europe which keeps Greece in the euro and is accompanied by genuine attempts to reflate the European economy, could be seen as a major positive for global markets,” says David Kelly, chief market strategist at JPMorgan Funds.
Over the long term, Mr Doll believes valuations for stocks are compelling: “Assuming that the world is not headed for a renewed deflationary spiral, there is little doubt in our view that stocks are poised to provide superior long-term returns over bonds given their current levels,” he says.