The particular set of differing actions and directions of travel of among the world’s major central banks is unprecedented, and getting a read on the implications of this is likely to be a big differentiator between investment winners and losers during the second half of the year and beyond.
Never before have the major central banks in the world been gearing up to move in such contrasting ways and therefore it must be considered the biggest broad investment risk for the rest of this year, but perhaps also the best opportunity.
The US Fed is as always a key factor in the global economy and the main question now is how the transition away from quantative easing will play out. According to the BlackRock Investment Institute, which gave its mid-year update yesterday, the key risk here for the second half of the year is how markets will react if the Fed departs from its ‘mantra’ of lower for longer on interest rates.
The European Central Bank meanwhile is poised in virtually the opposite stance with expectation building that it will enter into a programme of full quantitative easing following on from an inital raft of measures announced in June. Mario Draghi has set his stall out to stave of the threat of deflation and peg back the strength of the Euro but it remains to be seen how far he will have to go -or is willing to go- to achieve this.
Then there is the UK, where Mark Carney and the Bank of England monetary policy committee are treading a tightrope on when the first interest rate rise will come, swaying one way then the other but without falling off (so far). Meanwhile in Japan, the BoJ has been engaged in ‘Godzilla-like’ QE according to BlackRock, and the effectiveness of this makes it bullish on the country and its equities market.
The BlackRock Investment Institute now puts a 57% chance on its ‘low for longer’ scenario being the way the rest of 2014 plays out. To be more specific, it says it expects this central bank divergence to remain relatively benign in its impact at least for the rest of this year, with real rates and volatility staying low. Under this scenario there remains room for equities to move up further, even though valuations across the board are now 150% higher than the credit crisis lows.
The other way to looks at that however, is that there is a 43% chance that a major movement in markets for the better or worse will take place during the second part of the year, driven to some extent by the mix of global monetary policy. On the upside BlackRock sees a 27% chance of a ‘growth breakout’ in which real rates move up on rising inflation expectations and volatility returns. This would be ‘bad for bonds’ but create opportunities in cyclical assets.
On the downside, BlackRock puts a not-insignificant 16% chance on the imbalances in the world economy ‘tipping over’ as a downturn in expectations produces zero nominal interest rates alongside rising real rates. In this scenario a market sell-off would take place, volatility would spike, risk assets would fall and money would flow back to safe-havens like Treasuries and Gilts.
Whether you agree with these views and the approach taken by the BlackRock Investment Institute in its mid-year outlook or not, it seems clear that good forecasting on central bank action will be more essential than ever in the second half of 2014.
