Diverging economies and volatile politics to drive markets in 2015
With a bit of luck, the coming year for markets will not be very different from 2014 for investors in developed country equities. But bond markets could face a bumpier ride, and investors should look out for turbulence related to political worries in Europe and the strength of the dollar, says Stephanie Flanders, Chief Market Strategist, UK and Europe, JP Morgan Asset Management.
The strength of the dollar is a side effect of the increasing divergence in economic performance and policy between the Anglo-Saxon countries and most of the rest of the world, as highlighted in the chart below.
(Source: Various national statistics agencies, FactSet, JP Morgan Asset Management. Guide to the Markets – UK. Data as at 31 December 2014.)
“Like the fall in the oil price, an orderly rise in the greenback should be positive for markets and the global economy, helping to keep US monetary policy looser for longer while supporting a recovery in Japan and Europe. But a more dramatic shift in the dollar’s value would pose graver risks for emerging markets and could threaten global financial stability if the US becomes the only game in town,” says Flanders.
Offering insight into the year ahead, JP Morgan Asset Management today releases its quarterly Guide to the Markets. The unbiased chart pack illustrates the most important market, economic and investment themes influencing the markets.
Key considerations for investors in early 2015 include:
- Investors in fixed income products face another tricky year, with less room for error than in 2014. With interest rates rising, but still exceptionally low, investors will need to be flexible in their approach to income but also mindful of potential liquidity risks in the higher yield segments of the market.
- Despite investor pessimism, the outlook for Europe looks a little brighter than in 2014 and offers scope for positive returns.
- Emotions can distort investment decision making; investors who are able to shake off behavioural biases to achieve a balanced portfolio and diversification will reap the benefits.
- Thorny outlook for fixed income underscores need for flexibility and diversification
Many investors were wrong footed by bonds last year, with many expecting long-term core government bond yields to rise. In the event, they were the best performing asset class of 2014, as real and nominal yields were pushed down by reduced supply and unexpectedly strong demand from major central banks and institutional investors.
As the charts below show, the yield on ten year US government debt is now lower than it has been for well over 95% of the days since 1964. Against that yardstick, equities still look relatively attractive, although the US earnings yield – the inverse of the price-earnings ratio – is also well below its historical average.
(Source: Tullett Prebon, Standard & Poor’s, FactSet, JP Morgan Asset Management. *The equity risk premium is the S&P 500 forward earnings yield less the US Treasury 10-year yield. Guide to the Markets – UK. Data as at 31 December 2014.)
“Even with short-term interest rates on the way up in Britain and the US, this is a lower for longer environment in which a modest overweight to risk assets makes sense. But at current valuations it is not an environment for dramatic double digit returns,” said Flanders.
With interest rates rising, but from a very low base, the message is that investors need to flexible in their approach to income but also protective of their capital.
“Spreads products still appear to offer good value, although higher volatility could hamper liquidity in the higher yield segments of the market. The best protection for investors is to keep diversified, and to only buy assets from high-quality issuers you are willing to hold on to,” said David Stubbs, Global Market Strategist, JP Morgan Asset Management
- Five reasons to change the tune on Europe
The eurozone continues to face important economic risks, with falling oil prices raising the short-term risk of outright deflation and political uncertainty weighing on markets – especially in Greece and Spain. But five factors suggest that the picture may be a little brighter than it appears:
- A potential turn in the credit cycle: we expect to see a modest uptick in the supply and demand for credit. As the chart below shows, this should be supportive of the broader economy.
(Source: ECB, Eurostat, FactSet, JP Morgan Asset Management. Guide to the Markets – UK. Data as at 31 December 2014.)
- A central bank willing to act: there is now a widespread expectation that large-scale official bond purchases – quantitative easing – will be announced in early 2015.
- A weaker euro: with half of European corporate revenues coming from outside Europe, the weakness of the currency ought to feed through higher sales and profitability.
- Less austerity: fiscal tightening started to ease off in 2014, after three years of government belt tightening, reducing the drag on the economy from spending cuts and tax rises.
- Slow but steady reform: gradual structural reforms, as evidenced by encouraging steps taken in Spain and Italy, for example, suggests progress is moving in the right direction
Against this backdrop, a mixed strategy for investing in European assets looks sensible, with the prospect of quantitative easing making core bonds attractive. However, the catalysts are in place for some growth-oriented stocks to move higher too.
“More than ever, differentiation and firm-level analysis will be key to success in Europe. Investors from outside the Eurozone will also need to factor in the potential for further falls in the value of the Euro,” added Flanders.
- Time to keep emotions in check
Individual investors often allow the way they feel about the world around them to influence their investment decision making, which is nearly always a mistake. Whilst this is not a new phenomenon, it has been particularly evident in the years since the financial crisis. Since the low point of investor confidence in 2009, the S&P 500 Index has surged 250%, providing a rare opportunity for investors to boost their retirement accounts. Instead, however, fund flows statistics reveal that many retail investors have instead piled into bonds.
The chart below shows the rolling annualized total return over different time periods for bonds, stocks and a 50/50 blend of the two. Almost anything can happen over short time periods, but even the very worst five-year rolling return for a 50/50 blend of stocks and bonds – including the financial crisis of 2008 – would have produced an annualised loss of only 1%. The longer the time frame, the clearer the point: there has not been a 20 year period since 1950 in which a balanced portfolio has generated less than a 4% annualised return.
(Source: Strategas/Ibbotson, JP Morgan Asset Management. Returns shown are per annum and are calculated based on monthly returns from 1950 to November 2014 and includes dividends. Guide to the Markets – UK. Data as at 31 December 2014.)
“The biggest risk for investors isn’t anything out there in the markets, it is human nature. As we enter what could well be a bumpier time for markets, investors should be thinking of ways to keep their worst instincts in check,” concluded Stubbs.