With interest rate rises likely, bonds are going to be a drag on portfolios. Investors should be in North American and European equities, according to investment manager Bermuda Investment Advisory Services’ latest quarterly market briefing. New investment opportunities are emerging in life science tools.
The market performance in 2013 has been all about developed market equities. Treasuries have barely yielded any return (0.36 percent), corporate bonds are down (-0.38 percent) according to the Corporate Bond 1-10 Year Index, and emerging market equities struggled, as the MSCI Emerging Markets Index dropped by 3.65 percent from January to mid-November.
“Year to date the [developed market] stock markets have done fantastically well, particularly in the U.S.,” says Mark Melvin, director at BIAS in Cayman.
U.S. equities are the clear driver of market performance with the S&P 500 up 26.22 percent through mid-November, followed by Europe, where the EuroStoxx 600 jumped 21.05 percent. U.K. stock market returns were equally positive, albeit not quite as strong with the FTSE 100 increasing by 15.9 percent.
The performance reflects economic growth meeting projections and stable corporate profitability, Melvin says. While revenue growth may have slowed down, corporate profits are robust.
Meanwhile, the prospects for future growth are positive with GDP trending upwards, whereas inflation in the United States is benign and recent interest rate cuts in the Eurozone are even aimed at preventing the threat of deflation.
Despite the impressive growth, the increase has not been steady but saw several periods of sell offs and rebounds. The most serious correction followed Federal Reserve Chairman Ben Bernanke’s speech in July which the markets wrongly interpreted as an early end to the Federal Reserve’s quantitative easing policy.
Not a bubble
Since then the Dow Jones has reached record highs, kicking off a debate about a potential equity market bubble. Robert Pires, CEO at BIAS, however, does not think investors are overly exuberant by moving into equities.
“We don’t think it is a bubble at this stage. I think there is enough caution still in the investors’ psyche that if the markets get too far ahead they just sell off,” he says. “And we see that as constructive.”
Technical indicators such as price momentum, the rate of stock price rises or falls, support the assessment that some market corrections may be ahead.
BIAS notes that price momentum is slowing in the U.S. with lower and shorter periods of strength that could be a sign of profit taking.
Market indicators, such as the Investor Intelligence bull/bear ratio comparing the rate of bullish to bearish investment advisors, are also showing sell signals. Pires says, investors need to expect periods when U.S. stocks are going down. “We do think there is room for some leveling off of the performance in the U.S. stock markets in the months to come. You can’t get new highs each and every week.”
In Europe, economic optimism is building, which will encourage people to spend and push GDP back into positive territory. And even though the stock price momentum is coming down, BIAS advises investors to stay neutral on European equities as the momentum declines.
Emerging markets are still the economic growth drivers, accounting for two thirds of global GDP growth, and their prospects have improved. But in the emerging markets, stock price momentum is still negative. This means for the time being investors are still better off in the U.S. and Europe, Pires says.
In fixed income, investors are already anticipating interest rate increases and the treasury yield curve is steepening. 30 Year Treasury yields have risen from 3 percent at the beginning of the year to 3.83 percent, BIAS notes.
Because bond prices will decline as interest rates go up, investment portfolios that hold long-dated bonds will suffer in a rising yield environment, which will take hold once the Federal Reserve’s tapering of its quantitative easing strategy begins.
A 1 percent interest rate increase for instance would cause a 5 Year Treasury note to lose 5.64 percent and a 10 Year Treasury note to lose 7.63 percent, according to BIAS.
Not surprisingly private individual investors globally are now following institutional investors by moving more strongly into equities.
“The answer is clear, bonds will drag on portfolio performance but their job in the portfolio and the reason they still need to be there is stability,” says Melvin.
Portfolio managers will therefore avoid longer maturities, structured products and lower credit quality assets because they will be impacted more strongly by interest rate hikes than short-dated plain vanilla bonds.
Short-dated Treasuries, in turn, provide virtually no return but still play a role to preserve capital, Melvin notes.
Life science tools – a new investment theme
When looking for new investment themes, BIAS is trying to find potential disruptors. “Disruptors are areas, companies or new technologies that really shake up the existing order,” says Melvin.
Life science tools are such a potential disruptor and area of innovation in healthcare. “It is somewhat like the Internet was to retail,” says Pires. “The innovation that the Internet brought to retail has changed the way retail takes place. This area of life science tools, in our view, is changing the way medicine is going to be practiced.”
Pires cited the Human Genome Project, which produced the initial draft of the human DNA sequence in 2001, as an example for the progress made in this subsector of healthcare. It took the project 13 years to generate the human DNA sequence using 23 laboratories at a cost of $23 billion.
“Today you can do the same thing in one lab, sequence the entire human genome in a few days at a cost of a few thousand dollars,” Pires says.
The new life science tools can be used to identify diseases but may also open up the way to personalized medicine and the treatment of individuals depending on their genetic makeup.
The major driver of the subsector is the identification of genetic predispositions. Other applications include genetic testing for the response to drugs and possible treatments, the diagnosis of abnormal cells, such as cancer, forensic testing, paternity tests or genetically modified organisms such as disease resistant seeds in agriculture.
Investments in life science tools become even more attractive as an alternative to pharma stocks. The big pharmaceuticals companies’ major drugs are hitting patent expirations and are being replaced by cheaper generic drugs, says Pires. This means less income to invest in R&D. U.S. pharmaceutical company Merck for instance already cut R&D expenditure for 2013/14. At the same time new drug pipelines are drying up.
Other reasons to invest in life science tools are that the $40 billion market is expected to double by 2016, there is merger and acquisitions activity taking place and there are no ETFs available yet, BIAS highlights.