Coping with normalisation in 2014
Hermes CEO Saker Nusseibeh looks forward to 2014…
Looking forward to 2014, we seem to have two reasonably solid foundations on which to build a forecast for the year. The first is that growth in the Anglo Saxon economies, especially the US has come through stronger and more solidly than anticipated by many, as evidenced by the stronger employment numbers in the US and the revision to economic data in the UK. The US economy seems to be well on its way to grow at around 2.75% while the UK economy looks like growing in the twos. In both economies, unemployment is coming down, so this is not a jobless recovery, and in both, the housing market, the bedrock of consumer ‘feel good’ seems to be on the path to a recovery.
The second is that in both economies the central bankers have intimated that although unemployment will likely fall below the ‘trigger’ 7%, they are likely to keep monetary conditions easier for longer, for fear of disrupting what they see a fragile recovery. This then gives investors a conundrum. We can see that the economic recovery is feeding into share price appreciation, but we also know that normalisation is inevitable. The problem is that we have no indicators as to what might trigger it, or how long this period of abnormality (strengthening economy/easy monetary policy) might last.
Elsewhere in the world, the outlook is a little less clear. In the Euro-zone, the economy remains anaemic, as seen from the most recent data from France, and heavily dependent on German economic health. Investors know that the banking problem in Europe has not been resolved, but merely fudged for a time. However, the key issue which is yet to resolve itself is to do with the tension between the federal nature of a monetary union and the confederate nature of the political structure. While many commentators will look out for indicators of a large fissure, I think we are likely to see the effects of this tension in many smaller ones. We had an indication recently with the restructuring of EADS. This was triggered by the company’s difficulty in competing in the defence market against two headwinds.
First and foremost, with austerity in Europe, defence spending has declined substantially. Secondly, the EU by banning the company to merge with BAE placed it at a disadvantage to the big US players (who are already supported by a bigger US military budget). The other issue that Europe faces is linked to its prolonged period of austerity and the stickiness of unemployment, and that is to do with the rise of political tensions. This is already being reflected in the rhetoric employed by even mainstream parties about immigration.
Finally, developing markets showed that they are neither immune from the economic cycle, nor de-coupled from the economic fortunes of the big developed blocs. The question there is not so much whether we see a recovery (we do, as evidenced by the recent Chinese export data), but centres around the sensitivity of these economies and their financial system to the monetary cycle in the developed world. One can construct an argument that Chinese companies have been benefitting (albeit surreptitiously) from the lower rates on the greenback, which then throws up the question, of what effect would tapering have on developing economies and their financial systems.
Taking all the above into account, we can probably reasonably predict that equities, including emerging market equities, will continue to make headway, on the back of improving earnings and strong balance sheets. The question is what will stop this shooting into overvalued territory? The obvious answer is fears about monetary tightening or about dislocation in Europe. Nonetheless, with yields at decade long lows and recovery outside the Euro-zone proceeding at a solid pace, equities will offer investors both a reasonable risk adjusted return and a hedge against the possibility of inflation.
The end of the easing cycle will also be interesting to watch. Besides a knee jerk reaction to the start of a tightening cycle in the bond markets with its ensuing loss in value, we may in certain markets see a situation where correlation between these two asset classes is positive, meaning they both rise, driven by, on the one hand, pension schemes looking to lock into inflation linked bonds to meet their liabilities as the interest rates go up, while on the other, the perception that tightening interest rates is the result of improving economic conditions that feed into a positive cycle in equity markets.
What of the other asset classes? For as long as we have this abnormal situation of prolonged low yield, some investors will continue to look for yield like returns, hoping to capitalise on anomalies thrown up by the dislocation in the banks, including regulatory capital, direct lending, property lending and so on. That is fine as long as they realise that higher yields come at the price of higher risk. At the same time, the underlying fear of the return of inflation (as a result of this long period of monetary easing) will lead many investors to seek to hedge their inflation risk using assets such as property.
An outlook is never considered complete without a currency outlook. Unfortunately, my wizardry is somewhat rusty, so I shall pass on that. Other than to say that, with the ECB prevaricating on QE in the Euro-zone and Germany first needing to ‘smell’ deflation before climbing down, the longer the wait, the more likely that Euro-zone misery will end up being compounded by a stronger Euro.
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