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The European investment strategy team at exchange-traded funds giant iShares, part of BlackRock, has released its 2014 outlook, in which it outlines three possible scenarios for the global economy in 2014 and pinpoints the ETF strategies for investors to consider in these instances.
The document, entitled “Through the Looking Glass”, also looks back at 2013 – a year of divergence with wide variations across asset class performance and flows.
Stephen Cohen, Chief Investment Strategist for iShares EMEA, said: “Developed equities have been the clear winning asset class in 2013, driven by the US and Japan in the first half of the year and a European turnaround in the second.
“Rather than a great asset class rotation, there were several mini rotations within asset classes. In fixed income, there was a rotation from broad funds into short duration, and in equities, from emerging markets into developed markets.”
Looking ahead, the document considers three scenarios: ‘Low for longer’, ‘Growth breakout’ and ‘Imbalances tip over’.
According to Cohen: “The outlook we think is most likely in 2014 is one where monetary policy remains accommodative. Growth will improve yet remain below trend, with consumers bound by subdued wages.”
In this ‘Low for Longer’ scenario, to which iShares assigns a 55% probability, potential investment opportunities include:
· Minimum volatility ETFs to provide a smoother way of accessing US equities, reducing the impact of political uncertainty in the US.
· Differentiating between ‘emerging markets’. Countries with strong current account fundamentals, such as Korea and Taiwan, should see more resilient performance amidst Fed taper concerns, as should China. A minimum volatility strategy for broad emerging markets exposure may provide more attractive risk-adjusted returns.
· European peripheral bond ETFs which offer carry compared to core Europe and have been a direct beneficiary of the ECB rate cut.
· Emerging markets and international dividend income ETFs. Emerging markets continue to develop as a source of income as their growth outlook matures, while valuations for dividend payers outside of the US remain attractive.
· High-yield bond ETFs, as spreads are still above historical default rates despite long-term tightening.
· Currency-hedged Japanese equity ETFs as data continues to suggest sentiment improvement in Japan and a potential deflation exit. The increasing correlation between equities and yen weakening means that currency-hedged strategies are still opportune.
The second scenario, ‘Growth breakout’, has a one-in-four probability, according to iShares.
“We estimate there is a 25% likelihood of a ‘growth breaks out’ scenario. In this scenario, corporate spending and bank lending increases in Japan and Europe, and stimulus-driven China grows as the country progresses on its reforms,” said Cohen
If this scenario plays out:
· Emerging market equity ETFs will benefit as investors re-allocate to the asset class.
· Brazilian equity ETFs will offer value if emerging market growth positively surprises the market in 2014. Beaten-up Brazil has been an underperformer in 2013 due to local monetary tightening and a deteriorating fiscal position.
· Rates will rise faster than current expectations. This suggests that in fixed income, ETF investors’ focus should be on high yield and especially in shorter duration bonds and interest rate hedged strategies.
The final scenario, ‘Imbalances tip over’, has a 20% probability and entails a number of risks for investors.
According to Cohen: “An alternative scenario, albeit the least likely, is for global economic imbalances to tip over. Europe’s sentiment led recovery fades and there is an emerging market funding crunch as liquidity is withdrawn. China’s ambitious reform agenda comes at the expense of growth to create such a scenario.”
In this environment:
· Safe havens are king, especially quality government bond ETFs.
· Minimum volatility equity ETFs could offer cushioned access to global equities in a risk off scenario.
· Gold ETPs could provide a crisis hedge despite a challenging 2013 for the metal so far.
· If rates remain low, the search for income will continue and dividend income ETFs with a defensive tilt and attractive valuations could prove popular.