Firstly, will growth become embedded in the developed world? In both the US and UK, economic growth is gaining momentum. In the US, the impact of last year’s fiscal drag is behind us, growth is building and job creation appears robust.
The financial system is working with a strongly capitalised banking system lending to the real economy. One could argue that with QE still very evident we should expect no less (stimulus is running at $75bn per month). Nonetheless the US economy looks well placed for 2014 and beyond.
A UK rate rise?
UK growth is also taking hold; again private sector job creation is strong, leading indicators are all signalling significant expansion, and the housing market in the South East is particularly buoyant. On the current trajectory we can legitimately consider the need for an interest rate rise this year, something not currently discounted by markets.
In Europe, again leading indicators are turning positive (with the exception of France). Even Spain appears to be finally emerging from years of austerity. Certainly peripheral bond markets have been on fire, with yields falling sharply as tail risks diminish. With a more robust global growth environment, policy measures will continue to normalise and long, and in turn short, rates will rise. Implications of this include rising borrowing costs for over-indebted governments and consumers, and a challenging headwind for fixed income investors. It’s also a scenario that lends itself to a stronger dollar.
A motorway pile up
The second question, then, is whether emerging markets will be challenged by tapering, rising bond yields and a stronger dollar in the way they were last summer. Last year’s car crash in EM debt and equities could be a pre-cursor to a full-blown motorway pile up later this year. Deficit countries more dependent on external financing have remained under pressure since then.
Both the equity and debt markets were standout underperformers last year, although equities had a bounce in the second half. The regions’ woes have not been helped by the new Chinese Government appearing to want to contain the explosive credit formation facilitated by the shadow banking sector. This has further undermined investor confidence, as has the prospect of a stronger dollar.
Nonetheless, if the region can withstand tighter (or at least less loose) US monetary policy, then real value will begin to appear. Bond yields are significantly higher, equity PE ratios are much lower than the developed world and at some stage the region will become attractive. For now though we need to see evidence of stability before considering increasing our exposure.
The final question is on corporate profits. Equity markets have clearly performed extraordinarily well over the last few years; the S&P 500 is up by 50%, the Financial Times Actuaries All Share Index up by 33% and the world equity index up by over 40%. Corporate profits have grown, but not nearly as much as markets have risen. So returns have been driven by a re-rating, fuelled by increasing confidence, ongoing central bank stimulus and liquidity provision.
Global growth takes hold
For equity markets to progress further we need corporate profit growth to take up the running – it’s unlikely equities can go much further without that happening. Returning then to our first question, if global growth takes hold there is every reason to believe the backdrop for corporate profit growth will be provided, although we will need to be mindful of the impact of falling unemployment on margins given current elevated levels.
There is one final issue to consider. We are nearly six years away from the global financial crisis (although it feels much closer in investors’ memories). Looking at past cycles, history would suggest we are now closer to the next crisis than the last one. Let’s hope that proves not to be the case.