The outlook for the world economy at the start of 2014 was arguably more attractive than it is now. We had expected markets to rise this year but we believed that the more cyclical sectors would lead. Instead, it has been a year when markets have been driven higher by moves in a narrow sub-segment of the market. Indeed, we have been extremely surprised by the aggressive declines in developed market bond yields this year (to 200-year lows in much of Northern Europe), as investors lowered their expectations for inflation, started to fear deflation (in Europe) and, as a result of increasingly scarce global growth, opted to aggressively pursue companies with stable and visible profitability above all else.
In short, it has been a year when earnings revisions have not been indicative of stock price performance, as shown in the charts below. For example, the right-hand chart identifies that year-to-date changes in 12-month earnings expectations for cyclical and defensive stocks are broadly in-line. The left-hand chart, however, clearly shows that the prices of these two styles of stocks have not moved in line with their similar earnings expectations, with cyclicals being significantly de-rated. Essentially, expensive stocks, sectors and geographies, have in many cases become more expensive.
Looking forward, however, while expectations for growth at the start of the year were high - across much of Europe at least after a strong rally in the second half of 2013 - they are now suitably lowered. This creates what we think could be a potential mismatch between valuations and growth expectations. As such, our portfolios are overweight Europe and also Japan while underweight North America and Asia, reflective of these valuation differences and divergent growth expectations. We retain a bias for more cyclical sectors over the expensive more defensive sectors.
Opinion column by Matthew Beesley, Head of Global Equities at Henderson Global Investors.