Nearly every major asset class saw decent returns in the first half of 2014, boosted by continued loose monetary conditions and a recovering global economy.
But this rally is “unloved”, according to Flanders, because investors know the days of cheap money and exceptionally low market volatility cannot last forever.
"Investors are looking for things to worry about in the second half of the year, and geopolitics and US monetary policy are likely to provide them. But even with the prospect of short-term turbulence, we think the environment still justifies a modest preference for riskier assets," she said in the firm’s third quarter market outlook.
Diverging policies
The focus remains on central banks, where diverging central bank policies between the US and Europe could cause volatility this year.
The stage is set for a clear divergence in policy between the Anglo-American markets and continental Europe, said Flanders.
In the US, fixed income markets have performed surprisingly well in 2014, in large part due to supply and demand dynamics in the market for long-term government bonds, especially US Treasuries.
But core fixed income markets are likely to come under some pressure in the second half of the year as the uncertainties hanging over the US recovery are lifted.
"It would not take much more evidence of faster growth and rising inflation in the US for investors to revise those expectations quite significantly. We think that could happen sooner than many now expect,” Flanders said.
Meanwhile in Europe, the European Central Bank has re-committed to "doing all that it takes" to confront the risk of deflation. This could see more money flowing into both core and periphery bond markets, and rates fall even lower, according to Flanders.
Stronger European earnings
With four consecutive quarters of positive real GDP growth the recovery is still moving forward and consumer confidence is continuing to rise – despite a loss of momentum in parts of Europe, particularly France.
This is expected to translate into modest growth in 2015, especially if the completion of the ECB's review of the state of European bank balance sheets and other policy measures improve the flow of credit to small and medium-sized companies.
Additionally, profit margins are on the rise and could be another driver of European corporate earnings. If companies are able to control costs as nominal growth picks up, profit margins should rise, though this is clearly going to take longer than many had hoped.
“Europe’s recovery remains uneven and credit conditions remain a challenge. But gradually improving economic data and changes in consumer behaviour do set the stage for a shift in earnings momentum,” according to Andrew Goldberg, global market strategist.
Balance and diversification
The struggle to generate positive income remains, despite fairly low conviction in the current market. Equities are no longer cheap and bond are looking expensive. This demands a thinking beyond traditional sources, and a multi-asset approach.
“We take a flexible approach, moving between investments, sectors and markets to find the best income. Our exposure to shares remain near record high, reflecting our preference for equity income over bonds,” said Talib Sheikh, fund manager of the Multi-Asset Income Fund said.
