Results from Sunday’s upper house elections in Japan appear to be a vindication of Prime Minister Shinzo Abe’s economic policies…..
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Johanna Kyrklund, Head of Multi-Asset Investments
Urs Duss, Fund Manager, Multi-Asset
For professional investors and advisers only.This document is not suitable for retail
Our multi-asset team provides its insights on current market trends and lastest asset allocation views.
Economic data supports our central scenario of an ongoing improvement in the global economy, driven predominantly by developed markets. With the exception of Japan, fiscal policies will become less of a drag. Given muted inflation, monetary policies are likely to remain stimulative. While credit conditions, particularly in Europe, may still be challenging, we do not expect a further restriction of credit. Finally, we expect commodity prices to be weak. Taking all these factors together, it seems the path of least resistance for the world economy is upwards.
Our main concern is that this ‘Goldilocks’ economy, which is neither too hot nor too cold, is reflected in asset prices. As a consequence, surprises in either direction are likely to cause turbulence. One surprise could be that the US labour market strengthens more than expected. The Federal Reserve has made it clear that it is committed to maintaining low interest rates until unemployment falls below 6.5%, but employment statistics tend to be lagging indicators prone to substantial revisions and are vulnerable to assumptions about the labour participation rate. As Figure 1 shows, the average monthly level of payroll growth required to reach the 6.5% target is not demanding. Likewise, the labour participation rate (Figure 2) is in structural decline due in part to a demographic shift as baby boomers are retiring.
Figure 1: Average monthly payroll growth (000s) required to reach specific unemployment rates given labour force participation, in 12 months
Source: Atlanta Federal Reserve, Schroders, 13 January 2014
Note:
Figure 2: US labour force participation rate
Source: Thomson Reuters Datastream, Schroders, Updated 13 January 2014
With investors focused on every twist and turn in the labour market data, there is a risk of a ‘Fed scare’, where bond yields rise further based on expectations of tighter monetary policy. However, we are reassured by the following factors:
1. Despite the recovery in industrial activity, inflation rates have been very subdued indicating a lack of demand in the global economy.
Figure 3: US yield curve – spread between the 10 year and 2 year nominal bond yield
Source: Schroders, June 1976 to December 2013
While we don’t expect a spike in 10 year bond yields, we recognise that any small increase in yields will require an improvement in earnings growth to protect equity valuations and equity returns. Given our prediction for US reported earnings growth is just slightly below consensus expectations of 10% (forecasts tend to be optimistic at this time of year), we believe equities could generate attractive returns in 2014.
Credit – reaching the end of the road?
As we enter 2014, spread levels across developed credit markets are tighter than they have been since the third quarter of 2007. This shows the extent to which spreads have now retraced since the global financial crisis. High beta sectors, such as financials, have outperformed, while low beta and interest-rate sensitive sectors, such as industrials, have underperformed.
With a strengthening US economy and European deflation risk appearing under control, developed market macroeconomic risks are starting to take a back seat. As a result, investors are increasingly focusing on relative value. This may well signal the end of the beta rally and the start of a less friendly credit environment. This is supported by our equity versus credit relative value models which indicate a preference for equity, alongside our macroeconomic analysis which also points to a more favourable environment for equity than credit. Looking forward, the risks of deteriorating corporate fundamentals and corporate activity are coming to the forefront. The US is more advanced in the credit cycle, with companies increasingly willing to spend their cash on merger & acquisitions and shareholder friendly activities such as share buybacks and dividends. This can be a double-edged sword: increasing leverage ratios for investment grade companies increases uncertainty and puts pressure on their debt financing, however smaller companies that are subject to buyouts tend to have their high yield debt paid down, decreasing their leverage.
Overall we remain neutral towards credit. Despite the risks outlined above, the cyclical backdrop is still supportive for credit, if not as supportive as for equities, central banks continue to take a cautious approach towards tightening interest rates and technicals remain supportive for now. However, we recognise 2014 is unlikely to see same risk adjusted returns as 2013.
Disclamer
The views and opinions contained herein are those of the Azad Zangana, European Economist and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
For professional investors and advisers only.This document is not suitable for retail clients.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.
Source: ETFWorld – Schroders
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