Turbulence is inevitable as policy tightening looms in the US and UK, says with the Eurozone falling back into recession and Chinese and Japanese economies cooling.

October 2014

Key points

  • We are neutral on equities and bonds.
  • We prefer equities in Japan and the Eurozone but are cautious on emerging markets.
  • US treasuries would be vulnerable if US rates were to rise as the fed has indicated.
  • The outlook for global real estate remains robust.

What goes up…

Equity markets have recently retreated from record highs set earlier in the year. Commodities have also fallen sharply, with a raft of data suggesting the Eurozone is falling back into recession and the Chinese and Japanese economies have cooled. Although the US economy has continued to strengthen, any comfort markets may have taken from this has been largely negated by a first hike in US interest rates drawing ever closer.

…doesn’t necessarily have to come down

Equities have historically struggled in the six months preceding an initial hike in US rates at the start of monetary tightening cycles. So recent events have not come as major surprise. Equally, we do not believe they mark the beginning of the end of the current bull market. The outlook for the world economy remains fairly bright, in spite of the deep problems facing Europe. And besides, monetary policy will remain extremely loose in the US and elsewhere, even if it does seem likely that interest rates have begun to rise by the middle of next year. 

Global outlook

In terms of the world economic outlook, we envisage robust growth in economic output of between 3% and 4% over the next three years, with ‘developed’ economies expanding by between 2% and 2.5%, and ‘developing’ ones by 5%. Global inflation will be moderate, which means more ‘quantitative easing’ seems likely in the Eurozone and Japan. 

US leading the way…

Within the developed world, the US economy will lead the way with GDP expanding at an annual average of 3%, helped by an especially buoyant labour market. Employment gains, greater household wealth from rising equity and house prices, less drag from fiscal policy and reduced political concerns are also contributing to the recovery.

With inflation likely to be pushed higher by services prices, it seems likely the Fed will start to raise the federal funds rate in the second quarter of 2015. Its own projections show a rate of between 2.5% and 3.0% by the end of 2016. 

… while the Eurozone may slip back into recession

By contrast, the Eurozone looks to be slipping back into recession. GDP growth stalled in the second quarter, with leading indicators and recent data revealing a further slowdown. Seasonal oddities may result in a small increase in the third quarter, but the underlying picture is bleaker. Further negative readings are quite plausible in the second half of the year and in early 2015. Combined with the obvious deflationary threat, this should be enough to lead to policy reactions from the ECB and – perhaps – from national governments.

ECB talking the talk

For now the ECB insists recent initiatives will help to ensure that growth resumes and that deflationary worries disappear. We do not agree and continue to believe that outright ‘quantitative easing’ (QE) is both necessary and inevitable. Renewed recession will also lead to calls for fiscal stimulus, which could rekindle strains between those Eurozone members who believe austerity is right and those – like us – who would like to see a more flexible approach. A sustained recovery is unlikely until QE resumes and Eurozone nations take much greater steps towards political and fiscal union. Banking union is only the first of many necessary steps in that direction. 

As we move closer to the start of policy tightening in the UK and US, the possibility of credit market turbulence grows

Stewart Robertson

Senior Economist (UK and Europe)

Identity crisis

Recession may also result in unemployment starting to rise again, renewing pressure on policymakers to respond. Such developments are likely to lead to further rises in nationalism and, in the extreme, populist protests. Although the ECB has indicated it will do all it can to save the Euro, another crisis of identity or existence should not be entirely ruled out, however unlikely.

UK continues to shine

Along with the US, the UK has the brightest outlook among the developed nations with most indicators arguing for a continuation of recent trends: robust growth and low inflation. The Bank of England has hinted strongly that interest rates will need to rise, without saying when. Two of the nine person rate-setting committee want to act now, but we believe a majority will not be ready to act until next spring. Slow, gradual rate rises are to be expected after that, with the terminal rate dictated by how the economy responds to the first monetary tightening for eight years. 

European exposure

Some cyclical indicators have recently suggested a moderation in the pace of growth in the UK, but not to a worrying extent as yet. However, the UK is far more exposed to developments in Europe than the US. The Eurozone is Britain’s most important trading partner. Weakness there will be felt here. 

Chinese slowdown

Chinese economic data has continued to disappoint. August industrial production data was particularly disappointing and implied that monetary policy will have to be eased if the government is to hit its economic growth target of ‘about 7.5%’. Stimulus measures announced earlier this year failed to fully revive the economy. Authorities seem reluctant to announce more, however. The property sector remains sluggish even though the government eased ‘home purchase restrictions’. Beijing is closely watching developments, but as part of its reform agenda would like to see the economy wean itself off this sector. A continued slowdown is likely. 

The law of Abenomics

As for Japan, optimism about the success of the authorities’ efforts to boost activity (so-called Abenomics) has faded. After the sales-tax-related boost to spending in the first quarter, the next three months witnessed an even worse offset. The economy actually shrank marginally in the first six months. Leading indicators are slightly less bleak but as far as enhancing growth is concerned, victory is far from assured. Further stimulus may yet be required, although Abenomics should eventually work. 

Regional selection over equities

The impending US rate hiking cycle has dampened our enthusiasm for equities, while credit has to overcome the headwind of rising US bond yields. Regional selection may provide more opportunities at this stage, especially Japanese and Eurozone equities given supportive monetary policy. 

We are underweight ‘emerging’ equity markets given the likelihood of higher US rates boosting the dollar – historically negative for this asset class. Within ‘emerging’ equities we prefer the markets of countries with strong manufacturing bases – China looks very cheap – relative to those of major commodity exporting nations. Commodity price falls have been significant and seem unlikely to reverse course any time soon.

Greater upside for Eurozone bonds

Sovereign bond yields are low everywhere. With some central banks looking to raise interest rates over the next year, they are vulnerable to sell-offs. And if the Fed raises rates in line with its own projections and treasuries slide, it will be hard for other bonds not to follow - these markets tend to be highly correlated. However, low inflation everywhere will limit the extent of any rise in yields. The prospect of weak growth and inflation in the Eurozone indicates greater upside for bonds in this region. 

Prepare for turbulence

As we move closer to the start of policy tightening in the UK and US, the possibility of credit market turbulence grows. Spreads tend to tighten slowly and widen abruptly. We would expect any such shake-outs to be short-lived as the backdrop of strong company balance sheets and low interest rates is fundamentally supportive for credit. Expect returns to be positive but unexciting. 

Prime mover

The outlook for global real estate remains robust. Occupier market fundamentals continue to improve with most prime markets seeing continued rental growth and lower vacancy rates. Property continues to offer good value relative to other asset classes and is attracting more equity. Meanwhile debt is becoming both more readily available and cheaper in most markets. Generally the outlook for capital growth is therefore positive. Having said that, while there has been no evidence of momentum easing, the risks of overpaying for prime assets in core markets is increasing.