Don’t be afraid of equities

This post originally appeared on benefitscanada.com.

Many investors have been actively reducing their equity allocations in the wake of the global financial crisis.

Though they’ve been heavily reliant on equity returns in the past, the market volatility of the past decade has been more than some investors can bear. Evidence suggests the assets that left equity mutual funds continue to rest in so-called safer assets.

Read:

• Tactical asset allocation
• From asset to risk allocation

It may surprise you to know that since the crisis, equity markets have performed relatively strongly, despite continued economic uncertainty and market volatility. In fact, for the four years ending November 30, 2012, equity markets in Canada and the United States have delivered returns of more than 10% and 8% respectively.

Emerging markets have offered almost 14%, and even poor Europe has handed out 4% (annualized, in Canadian dollars).

Read: Time to buy in Europe

Performance has been strong despite the mediocre global economic recovery due to monetary easing, supportive business conditions, robust corporate balance sheets, and increasing institutional investor risk appetite (from very bearish levels).

Investors’ appetite for riskier assets hasn’t been limited to equities either. Corporate credit has also delivered strong returns over the past four years, in excess of 10%. It’s also benefited from many of the same influences as equities, with corporate spreads narrowing in response.

Read: U.S. investor appetite returning

At this time of year, we start to think about the coming year and what it might mean for investors. Over the next year or so, the outlook is one of moderate global growth, with growth accelerating over the coming years.

Read: In 2013, look for the silver lining

Several key economies appear to be responding to monetary easing initiatives undertaken this fall.

Chinese data over the last month or so has picked-up, while the U.S. is returning towards a moderate growth path (assuming they avoid the fiscal cliff). The Canadian economy is expected to pick up into 2013 as U.S. growth improves and demand for our commodity exports increases.

Global growth rates have responded to these initiatives, and are modestly improving despite European growth, which remains stagnant.

From 2014 onwards, we could start to see U.S. household demand growth accelerate, as the mortgage debt overhang unwinds. In combination with trend growth from China of around 8%, prospects for corporate earnings may well be better than equity markets are pricing-in.

Read:

• A case for U.S. equities (2010)
• Canadian equities bounce back

On average, developed world equities continue to reflect an outcome of relatively weak real earnings growth and economic activity over the medium to long term.

Our forecasts are for more positive economic and earnings conditions, indicating equities are reasonably attractively valued over the medium term. This is especially so when compared against the prospects for government bond yields, which remain at unsustainably low levels.

While corporate profit margins have been relatively high over the past few years, conditions remain supportive for continued cost control—labour market slack, excess capacity and low interest rates.

The relative attractiveness of equity valuations still needs to be set against the economic and event risks that are still prevalent; Europe remains a potential source of market volatility, since the deleveraging continues throughout Continental Europe.

Read: Are equities dying?

In order to avoid a depression, rescue funds for impacted economies are needed, which in turn requires continued support from the stronger Eurozone countries, notably Germany.

Equity market returns have already discounted this repressed environment, but not one of Euro breakup or the default of larger countries such as Spain or Italy, which would undoubtedly lead to negative equity market returns globally.

So perhaps it’s time to take another look at equities. For investors on a path of de-risking, this might mean pausing for a while.

For those investors who are interested in being more dynamic in their asset allocation, it would seem maintaining or increasing investment risk could deliver potential benefits.

Read: Active investing is here to stay

Janet Rabovsky is a senior investment consultant with Towers Watson.