Schroders’ head of multi-asset investments, Johanna Kryklund, gives her outlook for the year ahead
“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that.” – Lewis Carroll, Through the Looking Glass
Equities well supported
Like Lewis Carroll’s Red Queen, central banks in the US, Japan, the UK and Europe have often appeared to be getting nowhere in their attempts to generate economic recovery. However, in their determination to do whatever it takes to safeguard the financial system, fight deflation and bring down unemployment, they do now seem to be making some forward progress.
We expect their efforts will support continued economic recovery and maintain ample liquidity, meaning that the path of least resistance for equities remains up. While price-earnings multiples have already expanded significantly, we expect earnings growth should help to deliver high, single-digit returns from developed market equities in 2014.
Government bonds set to be buffeted
Just like this time last year, we expect the main source of volatility to come from government bonds. Forward guidance from both the Federal Reserve (Fed) and the Bank of England now explicitly takes account of unemployment targets when considering a rise in interest rates. As a result, even though the likelihood is that central banks will keep rates pinned to the floor, forward guidance could create confusion amongst investors as they respond to every twist and turn in employment figures.
To avoid getting whipsawed by data-driven noise, we remain underweight duration and are emphasising credit exposures which carry less interest rate risk, namely high-yield debt, asset-backed securities and leveraged loans. Within equities, we have shifted from rate-sensitive defensive sectors towards more cyclical areas.
Emerging markets still carry risks
The outlook for emerging markets still generally looks cloudier than that for their developed counterparts. The absence of inflationary pressures is allowing developed market economies to run ultra-loose monetary policies. In contrast, some emerging economies face a deteriorating trade-off between growth and inflation which, when combined with current account deficits, may constrain central banks’ ability to stimulate the economy.
Valuations across a range of emerging market assets have cheapened as prices, real exchange rates and yields have adjusted to the financial and economic challenges facing the region. Having avoided emerging market risk for a couple of years, the tempting valuations now on offer provide scope for tactical opportunities across a selective range of markets. Nonetheless, the structural impediments to emerging market growth make us more cautious on a strategic basis, so we continue to favour developed market risk for now.
Commodity prices could be tested in 2014
Our concerns about the emerging market macroeconomic picture also lead us to continue to avoid commodities. Since the last decade, commodity prices have been highly correlated with the growth in emerging market fixed asset investment and industrial production. High prices and expectations of continued rapid growth in emerging markets encouraged a significant increase in supply which, in our view, is likely to cause many prices to stagnate at best through 2014. Indeed, evidence of excess capacity in some parts of the emerging world poses a significant downside risk to prices.
Fed moves should support the dollar
We believe that the key driver of currency movements in 2014 will be the divergence in monetary policy among the major central banks. We expect the Fed to start the gradual process of ‘tapering’ its asset purchases in March, while the Bank of Japan will remain focused on curtailing the growing deflationary threat.
Consequently, we remain long of the dollar against the yen. Emerging market currencies are likely to suffer periodic corrections as the Fed begins to ‘normalise’ monetary policy by slowing the pace of quantitative easing. As a result, we will continue to avoid those currencies in countries with weak growth and twin current account and budget deficits, which we believe will be most vulnerable to Fed action.
Deflation remains the biggest risk
In terms of risks to our forecasts, our concerns remain more focused on deflation rather than inflation. Indeed inflation is very much the dog that hasn’t barked so far. Measures of inflation continue to indicate a cool demand picture, which is mirrored by a lack of corporate spending. Ultimately we need to see economic confidence improve more meaningfully: central banks ‘running to keep in the same place’ is not a sufficiently solid underpinning for sustainable growth.
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