Sharp divergence of developing and emerging indices

Jun 10 2009 by Iain Laing, The Journal

MAY proved to be another decent month for equity markets with all major markets participating in the rally. Over the last three months the MSCI World index has gained more than 20%, but the interesting point to note is the sharp divergence between the developed and emerging market indices.

Emerging markets have gained 40% over the last three months, led by Asia.

We remain impressed that the equity market has shown such resilience following such a sharp recovery.

That said, the economic backdrop has undeniably improved. Last week saw the usual start-of-month release of the purchasing managers’ manufacturing indices (and the sister Institute of Supply Management indices in the US). The news here was universally positive, with upside surprises seen in most regions. Jobs data in the US also provided a shot in the arm for risk appetite, again suggesting that the worst may now be behind us. In terms of the global economy, our current thinking is that while we are still in a deep recession, the signs are that it is bottoming out.

As we expected, the US is leading the major economies, but China and its Asian trading partners are doing better still.

Regionally, our overweight position in Asia excluding Japan has paid off handsomely over the current quarter. While this has started to put some pressure on valuations, the superior economic outlook for the region over the short to medium-term leads us to conclude that the outperformance can continue for a while yet.

In terms of overall equity positioning, we still believe it is appropriate to remain cautious and add risk to portfolios in a selective manner, particularly as there are still some headwinds that could blow the recovery off course. The second-quarter earnings season is now less than a month away, and initial estimates suggest that this will be a fairly ugly affair. As we write, second-quarter earnings for the US are forecast to fall 36.1% year on year following a 35.6% fall for Q1.

All sectors are expected to report year-on-year declines, with materials and energy being hardest hit.

In terms of global sector positioning, the huge outperformance of materials is now fully reflected in the sector’s valuation. In the near term we believe that the sector could struggle, especially if markets do experience a period of choppy trading over the next few months. With this in mind, we are downgrading the sector back to Neutral for the time being.

The notable exception to this is the UK, where we are retaining a small overweight. In the UK we believe the outlook for the mining companies should remain favourable given demand recovery, supply constraints, various M&A possibilities, and decent valuations. To counter this downgrade, we are upgrading utilities by one notch, retaining an underweight, but less aggressively so than before. The rise in energy prices is a positive for the sector given its enviable pricing power, and this should be reflected in earnings over the coming months.

Overall, we maintain our preference for cyclical sectors, expecting further outperformance over the coming month as the economic recovery gains traction. That said, it is likely that defensives may enjoy a period of catch-up in the short term, as relative valuations adjust in response to the strong market rally.

Andrew Miller is regional office head of Barclays Wealth