assessing the risks as markets normalise

The road back to ‘normality’ is likely to be bumpy as investors adjust to this new landscape, and the muted year-to-date returns from most asset markets are perhaps testament to this.

 

The year has also been characterised by noticeable switches in investor positioning. Areas of the market that had been favoured for robust fundamental reasons suddenly became vulnerable to attack. This pattern was particularly pronounced in Japanese equities – one of last year’s strongest performers and the weakest among the developed markets (DM) year-to-date. Japan’s recovery has been called into question after delivering a string of data disappointments on exports, trade and gross domestic product (GDP) so far this year. This has come at a time when the market is expressing fresh doubts about the effectiveness of ‘Abenomics’ and is rightly concerned about the impact of the recent rise in Japanese VAT (on 1 April).

 

We feel that Japanese data has been unhelpful, but not necessarily damning. Admittedly, export data have failed to pick-up as much as hoped, despite the considerable weakening of the yen across 2013. Similarly, Japan’s reliance on importing energy is unlikely to disappear any time soon and will have a structural effect on trade dynamics. Importantly, however, inflation data is improving; the labour market appears to be tightening, putting upward pressure on wages. Stronger domestic demand looks to be behind the rising prices of durable goods. 

 

For our part, we suspect that the impact of the sales tax rise will be less serious than feared. Japanese fundamentals are much stronger than they were in 1997, when the last increase in the sales tax had a severe restraining impact.

We must also not forget that the Bank of Japan remains extraordinarily committed to generating inflation, and we are confident that a true lapse in momentum will be met by fresh policy initiatives. The early part of the year has effectively seen a significant level of position clearing, and investors are not as exposed to Japan as they were towards the end of 2013. Yen strength this year led to a reversal of the carry trade as investors withdrew their money from emerging markets (EM). This is a potentially problematic feedback loop that must be acknowledged and positioned for, but we think that ultimately collateral damage sustained from the carry trade will not be long lasting. Japan remains one of our conviction positions on a longer-term view.

The effects of the unseasonably cold US winter (caused by the ‘polar vortex’) will soon work their way through US macroeconomic data, and with that we will start to get a much clearer picture of underlying growth and what that may, or may not, mean for US monetary policy. Undoubtedly, stronger US growth in 2014 would be a tailwind for risk assets in the long run. However, if data surprise strongly to the upside, this could produce a period of more significant market volatility in the short run as it would necessitate a rethinking of the profile for the federal funds rate, and inevitably other interest rates around the world. On the flip side, if it becomes evident that the weather was not to blame for economic weakness, we may once again see rallies in safe haven assets and vulnerability in cyclical regions and assets. Although our central scenario is that the US will resume a modest pick-up in growth this year, we remain alert to the possibilities of a different outcome.

China is in the midst of a tricky re-balancing act as it moves deliberately away from being an economy that is export-led towards one that is more domestically focused. China’s vast growth over the past couple of decades has been driven largely by the mass mobilisation of capital and labour, rather than growth in consumption. As the government undertakes unprecedented structural reforms and necessary financial deleveraging, the risks of a policy error are increasing. There is an outside chance that a financial crisis precipitates in China. A mistake in judgement in reigning in credit, for example, could have dramatic knock-on effects not only locally in Asia, but in the worst case could trigger a global systemic shock.

News headlines have been dominated by Russia’s annexation of Crimea and the spread of the conflict across eastern Ukraine. At the moment, the immediate impact on the global economy of the crisis is limited in that Ukraine accounts for only 0.2% of global GDP. A more genuine threat is posed, however, by the potential disruption of energy supplies to Europe and any retribution visited on Russia through trade embargoes. While this scenario is neither in the interests of Europe or Russia, the impact of the conflict has already triggered a rise in Russian interest rates to protect the rouble and reduce inflationary pressures. The conflict as it currently stands is not driving our positioning, but it does contribute to our wider sense of caution about risk assets and our preference for DM over EM.

Our cautious outlook remains in place across equity and fixed income asset classes, with a preference for strategies that offer a degree of protection from current market levels, either through defensive positioning or contrarian holdings. 

 

The picture of economic growth in the US remains cloudy with the potential for both positive and negative surprises; however, our core positioning reflects a continued improvement in the US economy and hence the tapering of quantitative easing. We believe that the re-pricing of government bonds has further to go, largely shaped by the speed of US policy normalisation. We expect a slow grind higher in yields, albeit with the risks skewed towards more bearish outcomes. 

 

We continue to favour flexible bond mandates, limiting our exposure to interest-rate sensitive assets. Believing that valuations within high yield bonds have become somewhat stretched, we have trimmed our exposure here, adding a modest position in dollar-denominated EM debt on the grounds of relative valuation and an attractive yield.

 

The ongoing pattern of improving growth in DM is increasingly significant as the growth dynamics of EM weaken. Given this outlook, we remain wary of EM assets, and retain a preference for the DM equities of Japan, US, Europe and the UK.