But in Europe we’re sceptical about the predicted recovery. The repair of national balance sheets and restructuring of the financial sector is casting a shadow over the region. Unemployment rates are too high and productivity growth is missing. At best, growth will be anaemic, with notable downside risks.
The weakness of Europe’s financial sector is a headache. Faced with balance sheet pressure and increasing regulatory capital requirements, banks – despite politicians’ wishes – are still reluctant to lend. Without more lending to consumers and SMEs, how can there be strong growth? The ECB might lower interest rates further, but we wonder if this will work without the comfort blanket of fiscal stimulus, which governments have now taken away.
Emerging markets are reliant on global growth. The growth gap with the developed economies has shrunk recently, but we expect that the gap will stabilise during the first half of this year and widen again in the second half, particularly for countries with credible economic policies.
While not our central case, we’re keeping an eye out for a faster-than-expected slowdown in China, as policymakers grapple with non-performing loans and the risk increases that policy is over-tightened.
The risk of a major systemic quake, such as a government bond default or the collapse of a large bank, has subsided, leading to better confidence and more appetite for risk. The option to park money in ‘safe haven’ bonds is no longer recommended. There is widespread acceptance that the trend of declining interest rates is over. The debate now is not if, but when, and by how much rates will rise.
The benign economic outlook, low interest rates, reasonable valuations and high liquidity, continue to support a slightly overweight equity position in the first half of the year. Despite the less rosy outlook for Europe, European equities are more desirable on relative valuation measures, such as dividend yield, and because they have lagged US stocks, which now largely price-in the recovery ahead.
Emerging markets, in the short term, will be overshadowed by the shrinking growth gap with the developed world, political uncertainty and risks from QE unwinding. However, later in the year, as the growth gap starts to widen again, we expect to reverse our current underweight position in emerging markets to overweight. We’ll focus on consumer-related stocks, because of the long-term shift towards domestic demand and regionally we will favour Asian countries.
While it’s a consensus view to be underweight government bonds, we believe the shift out of bonds is not yet complete. With flat to rising interest rates (starting from historically low levels) and with the risk of rising inflation over time, higher yields are justified. This reverses the alluring risk/return relationship that we have all enjoyed in government bonds for the last 25 years. Over the next couple of years we expect marginally positive returns, but with (potentially large) downside risks.
Bond investors searching for yield will therefore look at corporate bonds. But investment grade bonds are too rate-sensitive and offer insufficient protection. So we recommend clients move down the credit curve and focus on the crossover area between investment and non-investment grade. Convertibles will be another interesting alternative, as they combine exposure to both corporate bonds and equities.
The months ahead offer plenty of economic policy uncertainty. There will be less synchronisation between regional growth cycles. Expect a bumpier ride than 2013 and look to shift more into absolute return strategies.
The impact of any policy mistakes will be huge. A long-term view on asset allocation makes little sense, it’s vital to constantly review the situation and take advantage offered by market dislocations.
While investment prospects are not as tasty as during the post-crisis years, there are plenty of opportunities. This is a great environment for active skill-based investors, looking forensically at fundamentals.
