Petering out liquidity weighing on emerging markets, bonds and gold – Julius Baer

While the economic recovery now under way in the developed world will gain additional momentum in 2014, major emerging markets are still dealing with the cyclical downturn they experienced this year, according to Julius Baer.

For the time being, the disconnect between these markets’ growth rates and those elsewhere in the world is at an end. Thanks to its export sector and despite its overvalued currency, Switzerland’s economy will continue to expand. With a normalisation of monetary and fiscal policy in the major economies now imminent, the world’s financial markets will be kept on their toes. Julius Baer’s analysts recommend that investors relinquish positions in asset classes widely perceived as safe havens – such as emerging-market equities, quality bonds, cash and gold – and direct funds towards convertible bonds, M&A equities, the Chinese currency as well as the healthcare sector with regards to thematic investments.

Exports to help robust Swiss economy gain momentum
Further economic recovery in Europe, Switzerland’s largest export market, will have a positive effect on growth in Switzerland. Following their volatile trend in recent months, Swiss exports are expected to turn in a more solid performance during 2014. In order to counteract the ongoing overvaluation of the Swiss franc – despite the CHF 1.20 floor against the euro set by the Swiss National Bank – most of Switzerland’s export industries have managed to remain highly efficient and competitive and are thus well positioned to expand their sales significantly even in markets with the moderate growth rates now being experienced in Europe. “Strong exports and further robust increases in domestic demand should propel Switzerland’s GDP growth rate above the 2% mark in 2014. This will provide the Swiss economy with a broad-based upturn, characterised by accelerating job creation, ongoing low unemployment and – thanks to the continuing strength of the currency – only limited inflation,” Janwillem Acket, Julius Baer’s chief economist, is convinced.

Complex eurozone restructuring is making progress and deserves better recognition
While the eurozone economies other than Greece can be expected to emerge from recession in 2014, their broad growth rates are likely to average only 1%, with inflation remaining low. Structural adjustments and deleveraging continue to depress demand. “These modest rates of economic growth will not be sufficient to reduce unemployment from its current high levels. Moreover, the continuing scarcity of bank lending in the eurozone’s peripheral economies could develop into a major economic risk in the medium term if it is not resolved during 2014,” Acket believes, adding that “as far as reducing private debt levels is concerned, the eurozone economies are at least two years behind the US and the UK, where growth rates should reach 2 to 3% next year.”
The current-account balances of the eurozone’s crisis-ridden economies, conversely, have been improving steadily since 2011, with these countries’ exports now either matching, or in some cases even exceeding, their imports. In the corporate sector, the continuing reduction in unit labour costs in Greece, Ireland, Portugal and Spain have also enabled these countries to achieve impressive gains in economic competitiveness. Unfortunately, similar progress has yet to be achieved in Italy and France, and there is thus some danger that these two major economies could jeopardise a sustained eurozone recovery. For that reason, Julius Baer’s analysts believe that the euro’s current undervaluation against the US dollar will be reduced only slowly.

Era of ultra-expansionary monetary policy drawing to an end
Although 2014 will see either a partial or a complete halt to the Federal Reserve’s current non-traditional monetary-policy initiatives, Julius Baer’s analysts expect that the first increase in the Federal Funds rate since the onset of the financial crisis will not take place until at least 2015 and possibly not until a year after that, as US unemployment rates eventually approach the 6.5% level. Central banks in Europe, Japan, the UK and Switzerland can also be expected to keep their key rates close to zero, so as not to jeopardise their still-weak economies. Conversely, a number of emerging economies – such as Brazil, India and Indonesia – have already had to raise their central bank rates in 2013, in order to keep inflation in check and counter the weakness of their exchange rates. Further increases in key interest rates in these countries cannot be ruled out in 2014. The notable exception to this picture among major emerging market currencies is the yuan, which, thanks to a combination of increasing liberalisation and sound fundamental economic performance, is now well on its way to establishing itself as an important trading and investment currency.

Generally speaking, the world’s major central banks will do everything in their power to minimise the adverse effect that any changes in their policies have on financial markets. In practice, however, the impact of such policy shifts usually proves more abrupt than intended, as the experience of recent years has demonstrated. Higher levels of market volatility thus seem likely in 2014.

From de-coupling to re-coupling
After several years of major distortions to historically established alignments, 2014 may well go down in the annals of financial-market history as the year of the big ‘re-coupling’. “Many rules which have provided good investment guidance in the disjointed financial climate we have experienced over the last twelve years could well prove ineffective in that role over the next few months or even years,” argues Christian Gattiker, Julius Baer’s Chief Strategist and Head of Research. There are, for example, a number of long-term trends which are either well advanced or already reaching a turning point. This is evidenced in equity markets, which de-coupled from global interest rates in the late 1990s and then entered into a long downtrend.

Now, however, Gattiker believes that “the much-acclaimed ‘new normality’ is showing clear signs of realigning itself with long-run averages, so that the risk premium on equities should continue to decline, to the detriment of fixed income investments.” From a macro-economic point of view, there is also notable evidence that investments in emerging markets and commodities no longer provide automatic protection against weak economic growth in Europe, as many emerging markets have now been exposed to capital inflows from the mature markets for too long, thus becoming over-dependent on the abundant liquidity those flows have brought in their wake. The resulting excess consumption and over-investment have created imbalances which will now have to be corrected.

In order to generate returns, investors will need to leave their comfort zones
Although market conditions have changed, many investors are finding it difficult to structure their portfolios accordingly. Many market participants (and this not only includes private investors) are at present too willing to lose money on fixed-income investments, gold or emerging-market shares, or to allow consumer-price inflation to deplete the purchasing power of their cash deposits. There is also great reluctance to invest in US shares at their current all-time highs or in European equity markets, some of which are now nearly 50% up on their mid-2012 levels. Yet, if investors wish to generate positive returns, they will need to leave their comfort zones.

2014 will be another year of investment opportunities. Bank Julius Baer’s analysts see further potential in the realignment of peripheral European capital markets with rising interest rates in Germany, in convertible bonds as an equity-related asset class, in the global market for mergers and acquisitions, in the yuan’s evolving role as a new global reserve currency and in the healthcare sector with regards to thematic investments. As Christian Gattiker puts it, “Like every other year, 2014 will provide its fair share of crises and problems, frequently testing investors’ stamina and resilience. Despite this, there is a good chance that investments in riskier asset classes will be ab

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