Greg Peacock: Three themes to inspire investor confidence

Shinzo Abe. Photo / AP

"This time it's different" - are usually the four most dangerous words in financial markets.

But there are three significant market themes emerging that persuade me that this time it may really be different. These emerging themes are important for New Zealand investors to understand.

The bad news stories about global markets are well known and a little tired by now - the more positive stories don't tend to get told.

Since 2008, most institutional investors have retreated to the perceived safety of fixed income at the expense of equity markets.

They are therefore underweight on equities relative to their benchmarks. Yet equities represent a much more attractive investment proposition as earnings yields exceed bond yields by a significant margin. Equities also have capital growth potential that fixed income does not.

When interest rates eventually rise there will almost certainly be capital losses for fixed income investors.

The risk reward balance over the longer term therefore is very much in equities' favour.

So, the first emergent theme is "the great rotation" - where large underweight investors will feel increasingly uncomfortable and belatedly cave in and buy equities.

New Zealand investors are well placed to understand the potential of this theme, having seen it drive local equities higher in recent months.

In their own right, global equities are probably somewhere between moderately cheap and fairly valued, but versus bonds they're the proverbial no-brainer.

The "coiled spring" is the next theme to keep a close eye on - where after a period of extraordinarily wild swings in markets following the global financial crisis, there has been a steady decline in market volatility, almost back to levels that existed in what we now know was a fool's paradise before 2008.

Markets have been oddly calm lately and history is very clear that such periods are followed by large market moves like that seen in recent weeks in Japan, where the yen has weakened versus the US dollar.

The significance of this is that historically, moves of this magnitude invariably create opportunities and many funds have captured the yen move already this year.

The third new and encouraging theme is the emergence of the "dispersion effect".

This relates to a persistent and direct correlation between stock prices and the global macro environment.

This correlation has meant that doing detailed analysis on individual companies has been a soul-destroying exercise because stock prices have moved up and down as a result of utterances from central bankers or politicians, rather than company fundamentals.

This had led to a significant pricing mismatch in the markets between good and bad companies but now the abilities of experienced and capable equity managers' stock-picking is being rewarded and the sector is much more confident as a result.

The net result of these three themes has been a stark change in the tone of meetings we have recently had.

Even managers who have found the past couple of years frustrating - code for saying they haven't made much money - are optimistic and energised.

The other point I have been sleeping on is a more positive view on the US economy and dollar, which would be a welcome development for NZ exporters and overseas investors.

A stagnant Europe, albeit one with periodic opportunities, was a recurring theme for managers, and China, while still an attractive market, was only given a cautious pass mark.

The most significant market exciting managers is the emerging story in Japan.

It is easy to be cynical about the periodic bouts of optimism on the outlook for Japan and the comments of Jesper Koll, Japan strategist at J.P. Morgan, still apply: "The first rule of investing in Japan is to never underestimate the willingness of the population to share pain. The second rule is to never underestimate the willingness of Japanese policy-makers to apply the first rule."

However, as I noted earlier, the argument that this time it's different is persuasive. There is now a genuine sense of the need for substantial reform in Japan, and this is necessary to create the political urgency to make substantive change.

The new Prime Minister, Shinzo Abe, is driving a radical agenda to break the deflationary spiral and seemingly inexorable economic decline.

The Bank of Japan, under new governor, and Abe ally, Haruhiko Kuroda, so long a protector of the status quo, and serial applier of Koll's Law is pushing change for the first time.

Meanwhile, the US seems prepared to accept a weaker yen to strengthen Japan as a bulwark against China.

Interestingly, we have had two meetings in California with managers who have Japanese analysts on the ground in Tokyo. Both remarked quite independently that the heads of those teams believe that this is the most significant event of their careers.

This too is part of "the great rotation" theme.

Japan has a huge government debt problem, nearly all owned domestically.

The yield on 10-year bonds is less than 0.5 per cent a year while the central bank is specifically targeting 2 per cent annual inflation. Compared to bonds, the appeal of Japanese equities that are still some 67 per cent below the peak of late 1989 is obvious.

Greg Peacock is head of research for NZ Assets Management.