The MSCI World equity total return index in US dollars is within touching distance of its 2007 all-time high, having risen by 131%* from a post-crisis low reached in March 2009. This strong performance, despite a disappointing economic recovery in the Group of Seven (G7) major countries, is attributable to three main factors.

• First, equities were attractively valued following the 2007-09 bear market. According to a forecasting model** employed by US economist and fund manager John Hussman, for example, US stocks were priced to deliver a 10-year return of 9.2% per annum (pa) at the March 2009 trough. The prospective return, admittedly, reached much higher levels in the 1970s and 1980s – it peaked at 20.0% in June 1982. The March 2009 forecast, however, was the strongest since 1992.
• Secondly, global growth has been respectable since 2009, despite a sluggish G7 recovery, reflecting the rapid expansion and increased weight of emerging economies. The IMF’s world GDP measure, calculated using “purchasing power parity” country weights, rose by 4.1% pa over 2010-12, above an average of 3.4% since 1980. The IMF expects continued respectable growth of 3.3% in 2013. World stock market earnings depend on GDP performance globally rather than in the G7.
• Thirdly, the liquidity backdrop for equity and other markets has been unusually favourable since 2009, partly reflecting extreme and unconventional monetary policies. A key liquidity indicator is the gap between the annual growth rates of G7 real (i.e. inflation-adjusted) money supply and industrial production. Faster expansion of real money than output implies that there is “excess” liquidity available to flow into markets and push up prices. This condition has been met in 34 out of 48 months since March 2009.

Applying a similar model to the MSCI World ex US index, for example, suggests a 10-year prospective return of 8.3%

What do these considerations suggest about current equity market prospects? The trend rise in global GDP and corporate earnings should continue to be supported by emerging-world catch-up.

Equity market valuation, however, is now much less attractive than in 2009. According to the Hussman model, for example, US stocks are priced to achieve 10-year performance of only 3.0% pa, well below the historical average. Mr Hussman, therefore, has been suggesting that investors should hold cash rather than equities until an opportunity arises to lock into a less unfavourable long-term return.

Such an argument may be valid for US stocks but carries less force in other markets, where valuation appears reasonable. Applying a similar model to the MSCI World ex US index, for example, suggests a 10-year prospective return of 8.3%.

A further consideration, of course, is the lack of appeal of other investment options – particularly government bonds and cash. The prospective 10-year return of 3.0% pa on US stocks is 1.3 percentage points above the current yield on US 10-year Treasuries*.

Many fixed-income investors, moreover, achieve exposure via funds that maintain a constant proportion of long-term securities rather than buying a 10-year bond to hold to maturity. They are, in other words, exposed to a risk of capital loss if either real yields revert to their historical average or inflationary expectations rise. US equities, in other words, may be priced to deliver a modest return but still appear attractive to bonds.

Valuation is the key driver of long-run performance but shorter-term equity market movements usually reflect the global economic cycle. A strong rally since mid-2012, for example, anticipated a pick-up in economic momentum in late 2012 and early 2013. This pick-up, in turn, was foreshadowed by faster global real money expansion from spring 2012 – the real money supply leads economic activity by about six months, according to the monetarist rule.

Summing up, equities are much less attractive than in early 2009 but are nevertheless likely to outperform cash and government bonds by a significant margin over the long term. Investors seeking to deploy new cash, however, may wish to delay pending a possible economic slowdown later in 2013, which may create a better entry opportunity.

*As of 17 April.

**The model assumes growth in dividends, earnings and nominal GDP of 6.3% pa – based on post-war experience – and mean reversion of the ratio of market cap to GDP over 10 years.

It’s the beginning of the second quarter and it seems like quite a good time to look back and review what’s happened in financial markets over the last two or three quarters and to look forward into the spring and summer months.

In terms of the period gone by, perhaps against all odds it’s been a good period for financial markets. There have been good results from equities but other asset classes have performed well and the driving force behind that, in our view, has been once again activity from the world central banks. The second half of 2012 was characterised by a lot of policy in the US, in Europe with the OMT and then, towards the tail end of the year, in Japan with the surprise elections and change of guard at the Bank of Japan.

We’ve seen investors embrace particularly European equities for the first time in a while

And it was those things that really energised particularly equity markets and drove strong performance. The impact has been quite considerable in terms of portfolio positioning. We’ve seen investors embrace particularly European equities for the first time in a while and cash has moved into equities in a more meaningful way than we’ve seen for a long time but also into bonds. We don’t believe that the great rotation that’s been talked about has really gotten underway. There hasn’t been selling of bonds but rather a move into both bonds and equities.

In terms of where all that leaves us, our expectation is that the second quarter may well be a period of consolidation for markets. The policy that I described as characterising 2012 is not going to be as noticeable in the US. It’s likely that the discussion will probably revolve around when and whether the Federal Reserve is going to start to wind down quantitative easing. In Europe the likelihood is that there won’t be much in the way of fresh initiatives from the ECB.

Perhaps in Japan we’ll see a bit more but in the main policy’s going to be less of a dynamic than it has been for markets and that means that, with prices having risen a fair way, some of the wind is going to be taken out of the sales. I think, increasingly the markets’ attention is going to be paid to the growth side of the equation, looking for evidence of decent global growth, of stabilisation in global growth and there we don’t have particularly bright expectations but nor are we especially bearish. The world has muddled through for the last few years on the growth front and we think that’s likely to continue to be the picture.

What does that mean in terms of portfolio positioning? I think the temptation is to back away a bit from the equity market. We suspect that might actually be a mistake; despite the issues I’ve described on policy and growth front we don’t believe there are likely to be renewed fears of recession. We think that in Europe the crisis is going to continue in this chronic rather than acute phase and that’s a backdrop against which investors, we think, will continue to be interested in yield and searching for yield. That leads them almost inevitably to certain parts of the equity market and towards the higher-risk end of bond markets. We think that trend may well continue into the second quarter.

So in aggregate, perhaps a flat quarter or a modest up-market in risk assets and equities in particular but within equity markets the leadership, we think, may continue to come from areas that offer yield, areas that offer some robustness in terms of business models and security of growth and perhaps areas of the world where policy’s going to be a little more accommodative, a little more stimulative than elsewhere.

As we are bottom-up stock pickers, macro views are not a key determinant of how we shape our portfolio. That said, a more positive macro backdrop will support our convictions. Although eurozone headwinds continue in the form of political deadlock in Italy, the Cypriot banking crisis and rising peripheral bond yields, a number of global equity markets remain close to five-year highs. Clearly, the recent Italian election result has provided a setback to Europe but this seems unlikely to cause an imminent return to euro fragmentation. On the contrary, there have been a number of recent positive signals for European equities; the return of Portugal to the debt market and signs that funding conditions continue to ease for European banks. Accelerating merger and acquisition (M&A) activity and a surge in buy-back announcements has also lent support to equities as corporates have put excess cash to work. Global M&A volumes in February surpassed that of last year’s while buy-back announcements in 2013 currently stand at a 20-month high.

Looking at the IMA monthly fund flow data, there has been a steady increase in the level of gross sales into the European ex UK equity sector – see chart. As Europe’s recovery gains traction and as gross domestic product growth forecasts increase, we would expect investor sentiment to improve and for fund flows to increase further, which should in turn drive up capital values.

Chart 1 – IMA: Gross sales to the Europe ex UK equity sector

Source: Investment Management Association (IMA), total gross sales by period (retail and institutional), in sterling, Jan 2012 to Jan 2013.

While we do not like to adopt a macro view, we do have a focus on buying good quality global players which originate from Europe but which are not entirely vulnerable to the region’s woes. Our portfolio is largely composed of companies with lots of free cash flow generation, on low valuations and with a good history of delivering strong results and value for shareholders. These companies should prosper even in tough times thanks to their exposure to faster growing economic areas and robust pricing power.

Currently, industrials are a particularly appealing sector and we are attracted to service companies due to their strong balance sheets and recurring revenue streams, such as Kone and Schindler. Kone, the Finnish lift company, has been able to tap fast-growing emerging markets as well as the developed world. The company’s servicing arm, which maintains and refurbishes lifts, accounts for more than half of Kone’s sales. At the other end of the spectrum, we have avoided financials. We remain underweight the sector and do not currently hold any banks. Banks have bounced sharply over the last six months but we continue to prefer service-related businesses with high levels of recurring revenue. However, we do own some high yielding insurance stocks such as Nordic-based general insurance provider Tryg, which is paying an attractive dividend yield, and non-life insurer Gjensidige.

European stock markets have recovered this year and are not as cheap as they once were. However, the Henderson European Special Situations Fund has a portfolio of companies with minimal balance sheet debt, strong underlying cash generation and most stocks have enjoyed excellent track records due to quality management who, in most cases, have significant exposure to their own shares. The underlying portfolio is yielding around 3.2%, and has an adjusted free cash flow yield in excess of 8% compared with other asset classes whose real value may be impaired by government initiatives to generate economic growth. Looking at the 1.9% yield currently earned on 10-year UK government bonds, European equities appear to be a much more sensible and attractive option.

Richard Pease is manager of the Henderson European Special Situations Fund, the Henderson European Growth Fund and the Henderson Horizon European Growth Fund

We are conscious of the rising risks represented by the Italian election result (demonstrating the increasing influence of populist politics as the electorate rail against the austerity approach) and the on-going saga in Cyprus, which again threatens to undermine the credibility of eurozone officials as they continue to adopt a case-by-case approach to each new crisis.  Whether Cypriot authorities insist on a levy on depositors or not, it shows that in a weak banking system with a weak sovereign, impairments are likely to result. At current market levels, the risk/reward in the eurozone periphery looks considerably less appetising than last summer, whilst investor positioning in credit is longer than it has been for some time.

Therefore, within the Henderson Horizon Euro Corporate Bond Fund we have taken advantage of the recent resilience to trade up in quality, targeting issuers that exhibit defensive characteristics, have demonstrable fundamental improvement, and have more of a global reach (rather than a domestic European focus).

·       Quality: securities from ‘core’ countries (evidenced by a sustainable debt position or independent monetary policy), companies that are globally diversified in terms of revenues and that have stable or improving credit rating momentum. Examples include bonds issued by BAT (global tobacco), Amcor (global packaging), and Telstra (Australian telecom).

·       Focus on alpha: deleveraging/turnaround stories that apply regardless of market direction or euro crisis. Examples include: Gecina, a property company that is reducing leverage (it was upgraded by both Standard & Poor’s and Moody’s in 4Q12); and GKN, a high yield issuer but with a credible strategy to regain an investment grade rating over the next 12-18 months

·       Global: European companies with low exposure to domestic Europe, and/or international companies issuing in euro

Our expectation is that good stock selection (alpha) will be more important than beta in driving returns in 2013.

It has been some time since the pharmaceuticals sector was feted as the poster child for growth stock investors. If you turn on the news today, you are likely to hear all about the threats posed by Obamacare, European austerity, patent expiries as well as overblown fears that the well has run dry on new drug discovery. Misery loves company and people are prone to believe it if you beat the drum often enough, so that potential risks become accepted facts.

Following this prolonged period of bearish sentiment, we believe that investors should look again at this unloved sector in Europe. We have been saying for some time that the pharmaceuticals industry is far better than general perception would indicate. I would go further and say that pharmaceuticals may be the biggest example of positive mean reversion in the whole of Europe, and that we may be only part way into what may turn out to be a decade-long bull market.

We renewed our interest in European pharmaceuticals two to three years ago, when the major players had single-digit price/earnings ratios (having been as high as the 30s in the late 1990s). At that point, companies were starting to increase their contributions from sustainable franchises offering long-term revenue security: businesses such as animal health, nutritional foods and vaccines. Yet investors were still pricing in the possibility that companies would fail to come up with replacement drugs to generate future earnings.

Developing new medicines is the lifeblood of this industry, but this is no different from any other industry. Peaks and troughs are part of the natural rhythm and it is the fallow period from 1998 to 2006 – when fewer new drugs were reaching the market – that wrongly shaped current opinions. In reality, research and development (R&D) pipelines were not ‘running out of science’. In fact, recent research in the UK has shown that the number of drugs introduced each year has actually increased on average since the 1970s.

What is true is that industry and market factors have forced pharmaceuticals to adapt, by reassessing and redesigning their business models and diversifying into new growth areas. Commitment to R&D remains strong, but it is much more focused, leaner and efficient than it used to be. More attention is being paid to managing the lifecycle of drugs to maximise returns. Major manufacturers are also entering into the market for generic drugs, or cutting the cost of their post-patent expiry products to slow the erosion of revenues.

We firmly believe that the story for European pharmaceuticals remains intact, with many companies well positioned to deliver long-term sustainable earnings and priced at attractive entry levels for investors. Given these factors, we continue to increase our exposure to pharmaceuticals and healthcare in general now makes up between 30% and 40% of our portfolios.

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