MAKE OR BREAK
As we approach the halfway point, 2014 is proving rocky. Emerging market currencies have been battered; political unrest has rocked Ukraine and is heating up in Thailand, Egypt and Venezuela; and unseasonably cold weather in the US and Japan led to a temporary economic freeze.
Perhaps more worryingly for markets, Ben Bernanke, architect of the Federal Reserve’s ultra-loose monetary policy, has retired. This leaves Janet Yellen with the unenviable job of calibrating the right pace of liquidity withdrawal as the US economy strengthens.
Given these uncertainties, should we be calling time on the global economic and asset price recovery that has been building since 2009?
We at Sarasin don’t think so. First, this remains an environment of financial repression, where short- and long-term bond yields are being held artificially low by developed-world central banks. Therefore the material ‘wedge’ between low bond yields and higher earnings yields is likely to remain. This in turn should continue to provide a nice uplift to growth and asset prices.
Second, EM currency and growth weakness is likely to translate into a period of temporary global disinflation in the months ahead. We expect this to trigger further loose monetary policy at the European Central Bank and Bank of Japan, since inflation in both economies is already dangerously low.
Third, along with continuing ample liquidity, we expect a solid global recovery led by the US. Though the weather led to a pause in activity, the economy should grow at an above trend pace (2.5 per cent). Consumer spending should pick up on the back of improving employment conditions, rising earnings and wealth, while business spending should also rise as a result of pent-up demand and ample cash flow.
Even government spending and the US political scene are looking more positive, thanks to the budget deal of late 2013 and the non-confrontational expansion of the debt ceiling.
Elsewhere, the UK should also enjoy strong growth on the back of a powerful policy-driven recovery in housing and employment. In Europe, the lessening pace of austerity and improving financial conditions should lead to a modest recovery, while in Japan growth should pick up as Abenomics gradually starts to extract the economy from two decades of deflation.
On balance, then, we expect a slight acceleration in global growth, driven by developed markets. We believe this environment of improving growth and ample global liquidity will remain very supportive of risk assets, particularly global equities. Increased confidence should continue to support investment inflows into global equity markets.
We remain cautious, though, when it comes to fixed income markets. Valuations are still expensive after five years of interest rate repression by central banks. Furthermore, parts of the high-yield credit market also warrant caution, as bubble-like conditions are leading to a surge in riskier areas like hybrids and cov-lite bonds.
In the emerging world, we are seeing value emerge in some sovereign bonds, especially in countries where policy-makers have taken aggressive action. India, in particular, looks promising as the monetary policy regime has been strengthened and more market-friendly policies look increasingly likely after the May elections.
Other countries — such as Brazil or Indonesia — could ultimately benefit from a return of the carry trades (ie investors taking advantage of interest rate differentials between local rates and developed market rates), even though they are likely to remain under pressure in the short term.
It seems, then, that interest rates will trend higher across emerging economies to support local currencies and prevent capital flight. While this should ease market tensions, domestic demand is likely to struggle. We therefore remain cautious regarding EM equity markets, though some export companies look increasingly competitive, and countries with ongoing reform processes (like Mexico and China) could provide some good restructuring opportunities.
As Europe and Japan battle deflation, we expect the euro and the yen to weaken further. The BoJ has already committed to doubling its balance sheet and is likely to announce new measures over the coming months. The ECB, meanwhile, will likely be forced to take further action to prevent deflationary risks from building.
So, better growth momentum from developed economies and further central bank action should combine well with attractive relative valuations. Taken together, equity markets should continue to be relatively well supported.
Subitha Subramaniam of Sarasin also contributed to this article