The peak of the liquidity-driven market and the rebalancing of global growth will have different effects across developed and emerging markets.
At the close of 2013, investors were perhaps becoming a little complacent about the equity market. The seductive language of all-time highs, instant profits and long-term growth continued to drive flows even as the Federal Reserve (Fed) made it clear it was intent on turning off the taps.
While the crisis years were marked by a coordinated response from the major central banks to stem systemic risks, the journey back from that remarkable place is likely to be one that authorities increasingly take on their own. The Fed’s taper marks the peak of the liquidity-driven market environment and the start of a slow normalisation, but this will not be followed uniformly. Economies face their own unique blend of political, fiscal and monetary challenges which must be overcome to reach the next phase of the economic cycle.
Episodic volatility
Investors be warned: although economic confidence has helped tame volatility, the abundance of liquidity and a diminishing fear of systemic risks have also helped subdue market fluctuations. On the last few occasions when market volatility was this low, namely the mid-1990s and mid-2000s, equity bull markets were being driven by rapid growth and low inflation – we aren’t there yet.
As a result, episodic market flare-ups are to be expected as the return to fundamental-based investing occurs. The recent turbulence in emerging markets (EM) has been attributed to numerous causes, but has undoubtedly been complicated by the lid being lifted on the underlying fragilities of some individual EM countries.
Global growth broadens
The actions and communications from the major central banks will continue to determine how smooth the normalisation process is. Global growth is improving and broadening in the developed world, and we believe this will continue to be a major theme for 2014. For markets to progress, investors must be adequately convinced that policies are being correctly tailored to the strength of economic fundamentals. Each major economy is now at a different point on the curve and will have to act independently from its peers, adopting a certain degree of needful self-interest while not destabilising the delicate balance in global relationships.
Having pursued aggressive and early monetary expansion, the UK and US have seemingly reaped first-mover advantages from their consumption-led recoveries, but must now be careful to manage interest rate expectations. The unexpected vigour of the UK economy has taken many by surprise: the Bank of England (BoE) now anticipates growth of 3.4 per cent this year, the fastest pace in the developed world, and BoE Governor Mark Carney has been forced to row back from linking forward guidance specifically to the jobless rate. We believe it is a close-run call between the US and the UK as to which will tighten monetary policy first.
Risk of policy error
In contrast, Japan is a relative latecomer to quantitative easing (QE), and is only beginning to reap the payoffs from aggressive monetary stimulus – a weakening yen and inflation rising above one per cent for the first time since 2008. It has recently revamped two of its loan support programmes to boost corporate and household borrowing, and we suspect that stronger monetary stimulus is being kept in reserve for times of greater need.
Further afield, the European Central Bank has done an admirable job of damping the flames of contagion from Europe’s financial system, but its hand may be forced in deploying its own form of QE, if falling inflation threatens to derail its recovery.
Given the very different economic challenges that these central banks face, the risks of policy error are undoubtedly increasing. Authorities will need to employ all their skills in managing and communicating change to market participants, whether removing stimulus or choosing to add more liquidity. Thus far, the Fed has largely convinced investors to disassociate incremental tapering from interest rate rises, but if growth surprises to the upside investors could become fearful about policy tightening occurring earlier than 2015.
Diverging fortunes
While improving growth prospects for the developed markets are a key theme for 2014, this also plays into a second leitmotif for the year ahead: a divergence in the fortunes of the G10 versus EM. The growth gap has been falling since 2009 and is expected to narrow further this year. Structural EM expansion cannot continue indefinitely, and in contrast to developed market policymakers, their EM counterparts do not have significant options for regenerating growth.
The most fragile countries must contend with current account deficits that are both negative and widening. The implication for EM equities, which have witnessed extraordinary flows in the post-crisis grab for yield, is that investors may cast a heavy eye on fundamentals and take their money elsewhere. While some of the risks are arguably priced in, potential currency fluctuations must be factored into any investment decision.
Balancing the risks
The risk of volatility flare-ups, the fragmented approach of central bank policy responses, and potentially dormant systemic risks mean that the road back to ‘normality’ may be bumpy: we think it makes sense to keep some firepower in reserve in the form of cash. We remain vigilant to potentially higher market volatility providing opportunities for us to tactically add new positions or increase existing ones on favourable relative valuations.
On a broader view, equities remain our favoured asset class as improving economic prospects and, by implication, policy tightening lead to a slow but bearish re-pricing of government bonds. The caveat remains that equity valuations have risen, placing a greater requirement on an earnings recovery, so we can probably expect lower returns this year than 2013.
After five years of central bank policy experiments, the return to a more balanced outlook for global growth and a more ‘normal’ market environment is unlikely to be straightforward.
Paul O’Connor is Co-Head of Multi Asset within the Henderson Multi-Asset team.