Risk rally could be moving too fast

The first month of 2013 saw global equity markets hit multiyear highs, US and German government bond prices slide and the euro reach a 14-month peak against the dollar above $1.35. But is this rapid improvement in risk appetite really justified?

Joost van Leenders, investment strategist at BNP Paribas, does not share the positive view markets have shown lately.

“In the US, the impact of the agreed tax hikes may have been underestimated, as has been the case in many countries in the past few years,” he says. “And the fight over spending cuts in this year’s budget has yet to begin. In the eurozone, we are concerned about low growth and weak bank lending, while we do not see the Chinese economy accelerating soon.

“Corporate results have mostly been better than expected, but excluding financials, sales and earnings surprises have been fairly modest. Moreover, earnings expectations are still being reduced and most companies’ guidance has been cautious.

“Since we parked the proceeds of our recent equity sales in cash, we are overweight cash, which we prefer over other asset classes as we believe we are in a tactical trading environment.”

Divyang Shah, global strategist at IFR Markets, highlights the dangers of “going with the flow”.

“While it’s always difficult to fight the trend and the reversal of safe haven flows, we should be cognisant of the risks in believing things have truly turned the corner,” he says. “Peripheral inflows are strong – but have only partially reversed the €406bn that flowed out in the first eight months of 2012.

“Equity inflows are also strong, but they traditionally are in January, and this year we have seen the additional effect of investors trying to beat the US dividend tax rise. Bond market inflows have not reversed but remain strong, even as 10-year Treasury yields test 2 per cent.

“The problem is that tail risk bystanders are now being sucked in to play the peripheral and equity rally for fear of missing out and to make sure they don’t underperform benchmarks. This is one of those ‘trend is your friend’ type of environments that is very difficult to fight against.”

Jane Foley, senior currency strategist at Rabobank, says that, in reaching $1.35, the euro/dollar rate had now reached his long-term target – making her wary.

“While our view – that central bank accommodation coupled with expectations that the eurozone crisis is moving closer towards a resolution would hold up risk appetite – has essentially been vindicated, the move to $1.35 has been more rapid than we expected, leaving us slightly uncomfortable,” she says.

“This is largely because investors’ desire to move into riskier assets runs counter to the bias of organisations such as the International Monetary Fund, World Bank and Organisation for Economic Co-operation and Development towards revising down their estimates for world growth this year.

“The outlook for the eurozone started to improve last July when politicians underpinned the need for fiscal union – but there is still the potential for hiccups. While central banks will continue to support risk appetite, and the euro will retain an upward bias, we would also warn of the potential for pullbacks. Investors should remain on their toes.”