So far in 2014, markets have not behaved as predicted. Cast a thought back to the start of the year when the consensus expectation was for rising yields throughout 2014. Instead, we’ve seen equity indices reaching new highs, bond yields compressing and economic data suggesting that we are moving inexorably closer to higher Fed funds rates. So can we expect the rest of the year to be as surprising to investors as the first?
In our view, the US economy is moving from reliance on stimulus to a self sustaining phase, and as the business cycle matures monetary tightening will therefore be justified. The same cannot perhaps be said of Europe and Japan, both of which will likely rely on stimulus for a while yet, while many emerging markets face an uncomfortable period of adjustment relating to the recent rapid build-up in debt.
Such divergence creates an environment where uncertain global growth is likely to keep aggregate policy loose and long-end yields compressed. Meanwhile, strong corporate balance sheets, the low cost of capital and the gathering pace of the US recovery provide a benign backdrop for credit and equity markets. Certainly, there are longer-term structural questions about how imbalances created by quantitative easing (QE) might play out. But for the time being the gradual repair of the economy, together with the tailwinds provided by European Central Bank and Bank of Japan easing, may suggest a longer-than-average period of economic expansion.
With short-end rates likely to rise as the Fed starts to normalise policy, but back-end rates compressed by loose policy outside the US, we anticipate continued flattening of the US yield curve. We also expect equity to return high single digits and credit to remain attractive as a carry trade. While we expect a higher US dollar and anticipate a modest tightening of language as the Fed paves the way to higher short-end rates, we don’t expect this to translate to meaningfully higher volatility in most asset classes.
Of course, there are risks to this view—a policy error, or weaker-than-anticipated consumption in the US could cause an episode of de-risking. By contrast, a rapid acceleration of growth could trigger an inflationary end game. Nevertheless, we believe that light positioning in many asset classes, plus a general tone of caution among many investors, balances these tail risks. On balance, while we acknowledge the longer-run structural uncertainties, we believe the recovery will gain pace, in turn creating a positive backdrop for risky assets.
When we assess the investment opportunity set against this backdrop, we consider it from the perspective of multi-asset income investors. We remain pro equity with our equity positions remaining near their historical highs. Our exposure to global equities is allocated across global, emerging market and European equities and in our view improving global economic growth should continue to support this positioning. Within fixed income, our view is that US interest rates may rise as the Fed continues to taper asset purchases, therefore we maintain a short position in five-year US Treasury futures as a hedge against interest rate exposure gained through exposure to credit sectors, including high yield and EMD. Our positioning in high yield is lower than it has been historically. We remain relatively constructive on the sector because fundamentals are supportive and default rates remain low, but we are finding more attractive opportunities elsewhere.
Despite renewed concern over Europe, we maintain our allocation to the region, where we can find very attractive dividend yields and maintain developed market beta within the portfolio.
Some key themes in the portfolio currently include:
- Our positive view on the US has been reinforced by continued solid economic data suggesting the US economy remains on a recovery track
- The ECB’s actions (including the recent ABS purchases announcement) provides support for Europe and offsets the negative risks from patchy earnings and geopolitical risk
- Finally, US yield curve flattening continues to play out, but we expect this to be increasingly led by the front end as we approach the Fed’s “lift off” date for rate rises in mid-2015.
Talib Sheikh is manager of JP Morgan Funds – Global Income Fund, which reported AUM of €8.5bn at the end of August.