F&C’s Scott assesses the role of central banks in 2014
Ted Scott, director of Global Strategy at F&C Investments, discusses global investment prospects for 2014.
Since the financial crisis of 2008-09 central banks have played a much more significant and pro-active role in the economy that has had, and continues to have, a profound influence on asset markets. Central banks in the US, UK and Japan have all expanded their balance sheets aggressively through purchases of assets (mainly government bonds) and this policy of quantitative easing (QE) has resulted in a massive injection of liquidity into the economy, much of which has been invested in asset markets, especially equities.
With the new Fed Chairperson, Janet Yellen, assuming the role at the beginning of 2014, the prospects are that monetary policy will remain broadly unchanged unless there is a significant improvement in economic data, especially employment. Already she has set out her dovish credentials and stated that the economy is operating well below its potential. This means that tapering is unlikely to start before March at the earliest which is likely to underpin equity markets early next year. Furthermore, US economic data has been mixed recently and the rise in bond yields has contributed to an increase in mortgage rates that has put a brake on the expansion of the housing market. Any hint that tapering might start shortly will lead to a further increase in bond yields and mortgage rates, which the Fed will be keen to avoid.
There has been increasing optimism that the debt crisis has seen its worst days and the eurozone is on the cusp of a strong economic recovery. In the 2nd quarter of the year the eurozone emerged from recession after six quarters of negative growth, but the figures for the 3rd quarter were disappointing with only 0.1% GDP growth. In addition, inflation has fallen to a four year low of 0.7% and there is a threat that next year the economy will lapse into equilibrium of flatline growth and possible deflation. That would be a negative scenario for equities, especially as markets have risen strongly on hopes of a recovery in both the economy and company earnings. Following a 40% increase in valuation in the last 18 months the market is vulnerable to any shortfall in expectations. Meanwhile, bond yields are low, helped by the actions of the European Central Bank, and yields of the periphery countries could rise again if economic and financial targets are missed once again.
In contrast, the UK has benefited from a more aggressive monetary policy from the central bank and with measures to stimulate the housing market the economy appears to be well on the road to recovery. For the time being monetary policy will remain accommodative but, if the economic momentum continues, gilt yields will continue to rise and the Bank of England may be forced to raise interest rates late next year. This may not harm equities initially but, as the economy strengthens, the prospect for gilts looks bleak and higher yields will eventually have a negative impact on shares as the cost of capital rises.
The one area where valuations look attractive for equities is Emerging Markets (EM) that have significantly underperformed their counterparts in developed economies. This is partly because growth expectations were too high for the majority of EM but also because there was increasing concerns about the quality of economic growth and company earnings. The vulnerability of EM was demonstrated following the rise in US Treasury yields in the summer, which triggered a huge flow of funds out of EM and into developed markets and forced EM governments into emergency measures to protect their economies and currencies. The prospect of a further exodus of capital responding to the prospect of QE tapering in the US remains the main risk for EM in 2014. However, valuations are now sufficiently low to discount such risks and, unlike developed markets there is selective value. A case in point would be China where the GDP continues to grow apace and gradually reforms are being introduced to open up the economy and make it more transparent. If the reforms are successful it should add to investor confidence in the region.
Japan was the best performing equity market in the first half on 2013 as equities responded to the new economic strategy of the recently elected Prime Minster Abe. The policy of QE is even more aggressive than the UK and US and has helped weaken the yen and create improved economic growth and company earnings and even raise the inflation rate slightly. Although there is still much to be done, if the government remains committed to the new strategy there is a good chance that the economy may break free of the debt deflation trap that has shackled growth for over a decade. This should drive a further rally in equities, although Japanese government bonds could fall sharply in such a scenario.
Commodities have generally been weaker in 2013. In particular, gold and silver have fallen as investors have accepted that low inflation is likely to remain for the foreseeable future and the lack of return is a burden for portfolios in a rising yield environment. The price of oil has been responding to political risk as much as economic fundamentals and it is clear there is still a political risk premium baked into the price. With the prospects of shale becoming progressively more important for oil importing countries, the outlook is for further weakness in the oil price unless there is a major political event, especially in the Middle East. For industrial metals, the gradual slowdown in the rate of growth in China and other EM economies will continue to limit the upside in their prices.