What a quarter in financial market terms — a roller coaster that awarded us with a glimpse of the turmoil that we can perhaps expect once the interest rate cycle turns for good. But first things first:
Until the middle of May, all the major trends that had shaped markets over the last few years appeared intact: equity markets continued on an upward trajectory; bonds issued by Organisation for Economic Co-operation and Development (OECD) nations threatened or exceeded their previous lows in terms of 10-year yields, with spread products including European peripheral bonds, high yield and emerging debt tightening further; OECD currencies, and in particular the yen, continued to weaken, particularly against the renminbi. A continued lacklustre recovery in the US, doubts over China and emerging market growth and a euro zone hovering on the edge of recession supported the view that quantitative easing (QE) and the zero-bound interest rate policies of the major OECD central banks would continue for a long while yet.
In the middle of May, the US Federal Reserve (Fed) issued a statement suggesting that it may consider "tapering off" its current bond buying programme. As this had previously been positioned as open-ended and unlimited (something the Fed subsequently probably regretted), this brought forward the prospect of Fed tightening and an end to QE, promptly changing sentiment within the markets. Equities became more volatile and retreated from their multi-year highs. Emerging market currencies (again with the notable exception of the renminbi) weakened and 10-year US Treasury yields rose from 1.6% to above 2.2%. This volatility was compounded towards the end of the quarter with a less aggressive statement by Japanese policy makers suggesting some back-pedalling on their commitment to reflate (probably prompted by a fear of losing control over the now rising yields on Japanese Government Bonds). This led to a sharp reversal of one of the major trends that was still intact, namely the weakening of the yen. In a matter of days, the yen rose from 103 to 94.50 to the US dollar. To make matters worse still, at the time of going to print the German Constitutional Court began hearing a case testing the compatibility of the European Central Bank’s (ECB) Outright Monetary Transactions with German basic law, opening up the prospect of putting a cap on the "whatever it takes" commitment to save the euro. This jeopardized the tightening of peripheral spreads over German Bunds that had occurred since last summer.
Where will economies and markets go from here?
Our central scenario for a continued slow and gradual recovery of global growth without any significant inflationary pressures remains intact. Consequently, we believe that QE will remain in place for the foreseeable future, with the outside possibility of the ECB and the Bank of England, as well as perhaps the Bank of China, easing further still. The recent sell-off in bonds will probably reverse. In this environment, equities continue to provide the only liquid asset class offering protection from the financial repression in which OECD economies find themselves, with perhaps a shift in preference from defensive growth stocks to those that are more cyclical in nature. Emerging market assets will continue to remain volatile as a result of capital flows but the sell-off in some emerging market currencies, such as the Polish zloty or Turkish lira, should provide buying opportunities.
The second half of the year promises to be very interesting, and we will continue to be alert to the risks to our central, relatively constructive, "risk on" stance.