February saw equity markets largely recover the losses experienced in January, when markets suffered their worst reversal since the volatile May to June period of last year as a result of the US Federal Reserve’s indications of tapering quantitative easing.  Despite relatively mediocre earnings results and poor economic data from China, investor sentiment towards equities remains firm, buoyed by continuing speculative behaviour in internet and life sciences related companies and by reaffirmation from central banks of continuing easy monetary policies for the foreseeable future.  In addition, emerging markets for the most part rebounded from the lows reached in January, though Russia was a noticeable outlier as the conflict over control of the government in neighbouring Ukraine intensified.  The MSCI World index was up +4.8% for the month, with most major indices posting sizeable gains.  Brent oil was up +2.5% in February on the back of tighter supplies and the increasing potential for an escalation of conflict in the Ukraine.  Gold rallied +6.6% for the month and +10.4% YTD after demand for the metal returned on the back of a -28.3% price decline last year; China also overtook India as the world’s largest gold importer.  Yields on 10-year US Treasuries and German Bunds remained stable at 2.65% and 1.62%, respectively.  Rates have declined significantly from December due to reduced fears of substantial interest rate rises in the near term.  The Japanese yen and the US dollar also generally depreciated slightly against other currencies after rising in January on fears of accelerating deterioration in emerging market economies.

The major political event in February was political demonstrations against Ukraine President Viktor Yanukovych’s government, which turned violent after the government first agreed to a truce before instigating a military crackdown a day later.  The president fled to Russia, and Ukraine’s government was taken over by a fragmented opposition.  However, Russia has now intervened and invaded Ukraine’s province of Crimea (which has a Russian majority) and is threatening to attack other parts of the country.  Ukraine will also default on its debts in the near future unless it receives an international bailout, a situation compounded by Russian gas giant Gazprom now demanding US$1.55bn for unpaid gas.  These events took the shine off of Russia hosting the 2014 Winter Olympics.  Russia’s MICEX index was down -0.7% for the month and
-3.9% YTD.

In South Africa, the JSE All Share index was up +4.9% in February to hit an all-time high, more than recovering its losses in January when the rand currency collapsed -5.6% against the US dollar.  The market rallied on the back of strong GDP growth of +3.8% in the fourth quarter as well as renewed strength in private sector lending, potentially indicating an improvement in consumer confidence.   The rand also recovered from its recent lows to finish the month up +3.4% versus the US dollar.  Producer price inflation came in at 7% in January, which though high was in line with investor expectations.

The strong performance overcame continued volatility on the political front.  The opposition Democratic Alliance’s candidate for the presidency, Mamphela Ramphele (a heroine of the fight against apartheid), withdrew her candidacy after less than a month.  In addition, the National Union of Metalworkers of South Africa (NUMSA) is now preparing to launch a new political party, the United Front and Movement for Socialism, to champion the rights of the working class, which it feels the ruling African National Congress (ANC) is now ignoring.  This is part of an ongoing dispute with the Congress of South African Trade Unions (Cosatu), which backs the ANC and is now trying to suspend or expel NUMSA.  These developments will potentially fracture the opposition voter base for the upcoming elections in the spring, increasing the likelihood that the ANC will cruise to an easy majority.  However, if such opposition parties can firmly establish themselves as credible alternatives going forward, they can potentially improve the country’s governance.

Further north, Nigerian President Goodluck Jonathan sacked the widely respected governor of the country’s central bank, Lamido Sanusi, who identified multi-billion dollars of embezzlement activity from the government’s treasury.  This does not come as a surprise and the Governor’s tenure was already ending later this year.  The government is also beginning to lose control of security, with almost 300 people killed so far this year by the terrorist group Boko Haram in the northern part of the country.  Such poor governance is increasingly holding back the country’s development, though Nigeria continues to benefit from substantial growth in the working age population.  The Nigeria All Share Index was down -2.5% on the month and -4.3% YTD.

In the Middle East, Egypt’s government resigned following paralysing strikes across the country.  Elections are due in a few months, but the public fear the military will try to reassert authority over the government, with Field Marshal Abdel Fattah al-Sisi anticipated to run for the presidency.  Nevertheless, commercial interests tend to prefer the political stability that the military provides.  The EGX 30 index was up +9.8% in February and +19.8% YTD (as well as up +48.1% year over year).  The rise in the Egyptian market demonstrates how African markets have the potential to outperform at the same time as other larger emerging markets post poor results.

Further north, Turkish Prime Minister Recep Tayyip Erdogan was caught on tape telling his son to stash millions of euros offshore ahead of a public prosecutor’s investigation into government corruption, leading to an eruption of anti-government protests.  The BIST 30 Index recovered +1.3% in February though is still down -8.1% YTD.  The country may require an International Monetary Fund (IMF) bailout this year, as it does not have the reserves to cover the country’s high current account deficit.

The Japanese economy is almost solely dependent on the central bank maintaining its substantial quantitative easing programme, projected to be the largest as a proportion of GDP of any developed country since the Second World War.  Despite such scale of monetary stimulus, the economy grew only 1% in the fourth quarter of last year.  The Nikkei index fell a further -0.5% in February as a result after collapsing -8.5% in January.

Meanwhile, neighbours China and Taiwan held the first high-level talks since the end of China’s civil war in 1949. This hopefully increases the level of engagement and cooperation between the countries, helping to lower tensions in East Asia, which have been building over the past year.  China’s central bank also allowed the yuan currency to fall by more than 1% against the US dollar in an initial test of potentially widening the yuan’s official trading range.  This is the first major sign of economic reforms by the new government.  However, the country is still struggling to come to terms with the effects of a transition from an export-oriented economy to a consumer-driven one.  The purchasing managers’ index for manufacturing was 48.3 in January (below the 50.0 mark which signals expansion).  The Shanghai Composite Index was still up 1.1% on the month (though down -2.8% YTD) but with a great deal of volatility.  We note, however, that many domestic companies continue to post growth even in such an environment.

In Europe, the Eurozone economy grew by +0.5% in the fourth quarter of 2013 amidst continuing signs that the currency union is recovering from its series of debt crises between 2010 and 2012.  Portugal’s latest long-term bond sale was three times oversubscribed and its 10-year yield has fallen below 5%; this will aid the country’s efforts to follow Ireland out of the IMF’s bailout programme next year.  Portugal’s economy grew by an exceptional +1.6% in the fourth quarter, buoyed by increasing exports (41% of GDP now compared to 27% in 2009).  At the same time, the yield on Greece’s debt fell below 7% for the first time since its debt crisis and restructuring in 2010.  Investors also pushed the yield on 10-year Italian bonds below 4% to an eight year low after ratings agency Moody’s lifted its outlook for the country to stable from negative on decreasing concerns that the government will have to inject more capital into the country’s banks.  In addition, Matteo Renzi, previously the mayor of Florence, took control of Italy’s ruling Democratic Party and was elected as prime minister after ousting incumbent and fellow party member Enrico Letta.  Renzi comes with an aggressive agenda of economic and political reforms, which he aims to push through quickly. If successful, this may result in meaningful changes that improve Italy’s competitiveness.  Germany’s DAX 30 and France’s CAC 40 indices were up +4.1% and +5.8% in February, respectively (all major Eurozone indices were also up by meaningful amounts).

Mark Carney, governor of the Bank of England, broke the central bank’s linkage between interest rates and unemployment (after previously suggesting that rates would rise when unemployment goes below 7.0%).  Carney (as well as the leaders of the UK’s three major parties) also rejected any potential for Scotland to have joint control over the pound sterling, dealing a blow to Scottish nationalists who insist on continuing to use the currency.  The governor has had a charmed tenure to date with the UK economic recovery accelerating, boosting both the pound and equity markets.  The FTSE 100 index was up +4.6% on the month, more than recovering its losses in January.

In the Americas, Janet Yellen was sworn in as chairwoman of the US Federal Reserve, succeeding Ben Bernanke, and immediately reaffirmed her commitment to a continuing easy monetary policy.  This smooth transition of power at the central bank suggests that the Federal Reserve is likely to hold back from increasing interest rates until the unemployment rate is substantially lower or until inflation starts to pick up meaningfully.  The central bank was aided by the Congressional Budget Office forecasting the government’s fiscal deficit falling to 3% of GDP, roughly in line with its 40-year average, and by Congress’s passage of a debt ceiling increase without conditions.  GDP growth did slow to +2.4% in the fourth quarter of 2013, down from +4.1% in the third quarter, but this is likely the result of a 16-day shutdown of the government in October and an unusually cold winter.

Standard & Poor’s did downgrade the debt of American territory Puerto Rico to junk status, sending ructions through the US municipal bond market.  However, the impact of Puerto Rico’s likely default may be offset by the improving financial position of other US states and municipalities as a result of the country’s general economic recovery.  The state of Illinois is currently the only other major state and local government that has a high probability of default, though the city of Detroit filed for bankruptcy earlier this year.  The S&P 500 climbed +4.3% in February, hitting an all-time high.

As mentioned in last month’s commentary, emerging market indebtedness, economic imbalances and political instability have taken centre stage this year.  Though they are in better shape than they were heading into previous crises, some countries will require a number of years to resolve their issues.  The headline risks posed by large scale protests and in particular the conflict between Russia and the Ukraine will likely weigh heavily on investor sentiment.

Equities in general have outpaced their underlying earnings growth, leading to fair to expensive valuations.  However, with economic recovery accelerating in developed markets, it is likely that the equity rally will continue this year, though at a slower pace and with more volatility (likely to depend on when expectations of higher interest rates start to be priced into markets).

Sources:  RisCura, Bloomberg, US Energy Information Administration, The Economist.

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