Financial markets finished 2013 and began 2014 boosted by increasingly robust economic data from the US. This reinforces our conviction that the new year will see the global economy continue to benefit from a modest recovery that is gaining momentum, underpinned by a longer-term recovery in the US economy that is becoming more sustainable after years of weakness.
Against this positive background, it remains our core belief that investors should be prepared for continuing financial repression coupled with the reduction of sovereign debt through low interest rates in developed countries. These will continue to be the most important influences on capital markets in 2014.
Our view has been reinforced by the latest developments in America, where the continued recovery in the US labour market led the Fed¹ to announce a modest cut in its monthly bond purchases, to USD² 75 billion from USD 85 billion, beginning in January 2014. In addition, December US manufacturing reports were the best since last January, indicating continued strength in new orders and hiring. At the same time, the Fed has taken great pains to emphasise the separation of “tapering” from “tightening” (i.e., rate hikes), adapting to the strengthening US economic recovery without causing it to stumble by winding down QE³ too quickly.
This is exactly what we mean with our continuing call for monetary policy that will be “looser for longer”, even in the face of these initial cautious tapering steps by the Fed. We believe the role of central banks will become even more critical to markets in the future. Not only must they manage a smooth transition from pumping cheap money into markets to taking incremental steps to taper QE, but they also need to become expert at providing sensitive and well-timed future guidance on new monetary policy (i.e., possible interest-rate increases) in the face of a strengthening global economy.
The importance of managing such sensitive movements effectively became clear to central bankers after the market’s severe “taper tantrums” in early 2013, which resulted in rising bond yields and a sell-off in emerging markets. There is no doubt that, despite a modest recovery gaining momentum, the global economic recovery remains dependent upon QE.
As a result, we expect central bankers implementing new policies to be far more mindful of both the lack of inflation – inflation rates are actually falling in most developed markets – and the fragility of the global financial system. Indeed, although the Fed debuted its “taper talk” early in 2013, its “taper action” was far less aggressive than the market anticipated. The Fed wants markets to react positively to their plan, and it clearly does not wish to see asset prices deflate at a point when it is trying to reflate the real US economy.
In Europe as well, the latest ECB4 announcement at the end of 2013 of a new rate cut in the euro zone also confirms our belief that we will see looser monetary policy for longer.
The lessons for investors in 2014? Central banks will be cautious when implementing tighter monetary policy in developed markets and implementing new policies that will aim to surprise markets on the upside. As a result, we believe that investors who are not invested in risk assets to a sufficient extent may be disadvantaged, based upon a continuation of the financial repression dynamics that we have experienced in the last three or four years.
On that basis, investors should carefully review their long-term exposure to risk assets in the hunt for attractive long-term returns. While some parts of the market have recently reached highs, investors should look carefully for areas that still offer better value at more attractive valuations, and should make use of market weakness or corrections as long-term buying opportunities.