– We are introducing three new investment scenarios for 2014 against a backdrop of low nominal growth and markets driven by monetary policy choices. Low for Longer , our base case with a 55% probability, features tepid economic…
growth and loose financial conditions. Our bull case (25%), Growth Breakout, has economic activity accelerating and liquidity gradually tightening. Our bear scenario (20%), Imbalances Tip Over, highlights the many things that could go (very) wrong.
– We are living in a low-growth world that is slowly returning to normalcy – if we are lucky. We expect uS gDP growth to tiptoe to around 2.5% as the impact of tax hikes and spending cuts fades. We see the Eurozone eking out growth – but not enough to reduce debt loads. A slowing china is still set to be a major contributor to global growth (financial sector risks are its weak link). We are split on whether Japan’s growth plan will work. The good news: developed economies should accelerate in tandem for the first time since 2010.
– Our worry: global central banks may be pushing on a string. low nominal growth cannot be solved by monetary policy alone. ‘MQuantity’ (monetary growth) does not address skills mismatches, ageing populations, labour market red tape and protectionist policies. central banks can ease some of the pain – but ultimately policymakers must deliver structural reforms to boost growth.
– liquidity provision will grow more slowly in 2014 – and markets invariably focus on rates of change as much as absolute levels. We expect the uS Federal reserve to scale back its bond purchases, but use Low-for-Longer forecasts, or ‘forward guidance,’ to keep a lid on interest rates. The European central bank’s (Ecb) balance sheet is shrinking. The bank of England may raise policy rates on economic strength. The People’s bank of china is set to tighten slightly to reduce the risk of a credit bubble. The recycling of emerging market foreign exchange reserves is slowing.
– These liquidity-compressing measures will be partly offset by the bank of Japan’s godzilla-sized asset purchases. And we could see some form of quantitative easing (QE) from an Ecb worried about deflation. German opposition is a roadblock – unless the risk of deflation expands beyond Europe’s southern tier.
– Should we worry about the Fed’s (gentle) QE exit? It is not going to be a walk in the park, as some policymakers would like to think. We see it more as a triathlon in twilight. A healthy dose of humility is in order. The absence of a price-insensitive buyer will be felt. Policy words (forward guidance) replacing policy deeds (bond buying) equals a pick-up in rates and currency volatility.
– currencies matter – and not just for asset returns in a particular country. A weaker yen (cheaper Japanese goods) is a deflationary force globally; the Eurozone needs a weaker euro to export its way out of trouble; and a stronger uS dollar pressures emerging markets. Currencies will create winners and losers.
– As Low for Longer grinds on, imbalances grow. One is of particular interest to us as money managers: the potential for markets to overheat. Are we there yet? We do not think so. Irrational exuberance can last a long time. but much policy powder has already been spent, and we will be on bubble watch. 2014 is the year to squeeze out more juice from markets – and be ready to discard the fruit when it starts running dry.
– bonds have long been expensive. The problem for stocks: the numerator of the P/E ratio (price) is driving returns, not the denominator (earnings). Investors have jumped on the momentum train – effectively betting yesterday’s strategy will win again tomorrow. rising correlations between bonds and stocks are making well-diversified, ‘safe’ portfolios riskier than they appear.
– Diversification is like insurance: you do not need it – until you need it. consider alternative investments for 2014. Some are real diversifiers (at least in theory). We like market neutral funds and strategies focused on ‘hard’ assets such as infrastructure. The downside (illiquidity) appears a fair price for uncorrelated returns in a low-growth world.
Imbalances Tip Over
Economy: Squeezed real incomes, debt burdens or austerity cause recessions and/or china’s economy slows markedly. low inflation tips over into deflation.
Liquidity: central banks either tighten policy too fast or too late. capital flees emerging economies with external deficits.
Markets: A downturn delivers zero nominal interest rates – but rising real ones. Markets sell off on a QE exit or exogenous shock. risk assets fall and volatility spikes. Safe-haven government bonds get a second life.
Companies: revenues and profit margins fall. buybacks are suspended and some dividends cut. layoffs and cost cuts increase as companies hunker down for another recession.
Low for longer
Economy: growth is low and fragile, running close to stall speed. Jobs and wage growth are muted in the developed world. Inflation is low but stable.
Liquidity: Financial conditions stay very loose – but the growth of liquidity is slowing due to reduced Fed bond buying. The risk of QE-induced asset bubbles builds.
Markets: real rates and overall volatility stay subdued. Momentum can easily propel equities higher. The hunt for yield intensifies. low investor conviction in trades and lofty valuations leave little room for error.
Companies: corporate hiring and spending are lacklustre. revenues and margins struggle to expand. buybacks, dividends, and corporate issuance galore. growth companies demand a premium.
Economy: global growth gains momentum, pent-up demand is unleashed and animal spirits return, creating a virtuous circle. Inflation rises gradually.
Liquidity: liquidity provision is slowing – very gradually. central bankers somehow engineer smooth policy transitions toward (eventual) monetary tightening.
Markets: real rates go up, driven by rising inflation expectations. This is mostly bad for bonds and mixed for stocks (growth trumps income). cyclical assets (including commodities) should do well before rate fears kick in. Volatility rises.
Companies: revenues grow, and companies start hiring and investing again. Profit margins stay elevated – or go even higher. Mergers and acquisitions (M&A) boom.
– Markets cannot deal with tapering.
– real rates rise and nominal rates are frozen.
– Deflation in the developed world.
– rising correlations and volatility.
– Political dysfunction and populist anti-market measures.
– Middle East instability.
– Fading austerity delivers surprise growth boosts.
– confidence builds and leads to a virtuous circle.
– companies switch from buybacks to capex.
– The Ecb eases further.
– Progress on china’s reform plan.
– Abenomics actually works.
Source: ETFWorld – Blackrock