Developed-world stock markets recovered from their mid-year jitters to post healthy increases in 2012. America’s S&P 500 index, the pan-European FTSE Eurofirst 300 index and Japan’s Nikkei all rose by 10%-15%. So what now?
The fundamentals are uninspiring. In America investors are hoping that the slow recovery won’t be derailed by the ‘fiscal cliff’. But any deal to avert tax hikes and spending cuts kicking in automatically on 1 January is set to entail some form of fiscal squeeze. The issue is “how swiftly the US might tighten policy”, says Hamish McRae in The Independent.
Meanwhile, Europe’s recession appears to be deepening, China’s recovery is weak and the Japanese economy is set to shrink, says Capital Economics. Global earnings forecasts have come down, and with US margins in particular at historic highs, it’s hard to see much more scope for cost-cutting to boost bottom lines.
Throughout 2012, a poor fundamental outlook was more than offset by central-bank action. The European Central Bank calmed panicked markets by promising to buy up peripheral debt to keep borrowing costs manageable, while the Federal Reserve launched another round of money-printing.
Last week, it doubled down on the policy by making clear it would print until it sees healthy growth returning. This year, there seems less scope for central-bank action to juice stocks as strong support is no longer going to be considered so much of a positive surprise.
This highlights one of the longer-term factors affecting the market: since the crisis broke, stocks have been in a sideways pattern. Quantitative easing triggers rallies, but the sheer debt load in Western economies, which has hampered growth everywhere, caps the upswings. Whatever happens next year, this pattern is set to endure for a few more years, as it will be some time before economies have worked off their credit-bubble hangovers.
But this doesn’t mean stocks are a write-off. The key to strong long-term returns is buying markets that are cheap in terms of their cyclically adjusted price/earnings ratio (CAPE), as we have often pointed out. With many European markets historically cheap on single-digit CAPEs, defensive continental (and some British) equities are now worth loading up on. Japan is also a buy.