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Stephen Cohen, Chief Investment Strategist, iShares EMEA, offers his insight and perspective on the outlook for markets for the remainder of 2013.
The two themes that have dominated 2013 are changing expectations for central bank policy and the continued outperformance of developed markets amidst rising challenges for emerging markets.
For the rest of the year, the de-synchronisation of central bank policies and the diverging growth outlook that caused recent turbulence will remain key drivers of market uncertainty.
Liquidity and central banks, where next? The divergence of central bank policy
Unlike previous episodes since the global financial crisis, central bank policies are starting to diverge and communication is key – but remains a major source of potential volatility. Most in focus has been the Fed and the ‘will-they’ / ‘won’t-they’ tapering debate. Less in the headlines but equally important, the ECB and BoE have notably distanced themselves from any tightening implications with the introduction of forward guidance in order to keep expectations of short-term interest rates lower for longer. Meanwhile the Bank of Japan is in a league of its own, with its aggressive bond buying operations.
Less well highlighted is what’s happening in emerging markets. Several emerging market central banks (Indonesia, Turkey, India, China) have explicitly or inadvertently tightened funding in their lending markets in recent months. Most importantly, foreign exchange reserve growth in emerging markets has slowed sharply as competitiveness worsened and capital account balances declined. The recycling of these reserves to prevent currency appreciation has been a major source of liquidity for the world in recent years. The reverse, protecting currencies against a stronger dollar, portends tighter monetary conditions in many of these countries.
As central bank policies diverge, so do growth prospects. In Europe, the economy is witnessing a cyclical upturn amidst its longer-term structural rebalancing while in Japan the resurgence story remains on track in spite of the market pullback in May-June.
Japan’s resurgence story remains on track: Abe-nomics is working but reform agenda still to come
The impact of PM Abe’s first two arrows – “quantitative and qualitative easing” and fiscal spending ($130bn package) – is already evident. Data is surprising positively and domestic confidence in the Japanese economy is rising, feeding through to earnings upgrades. In the Q2 Bank of Japan Tankan, the major survey of business sentiment in Japan, indicators for large manufacturers were positive for the first time since 2011. At the same time, the Citi economic surprise indicator, which measures the economic data reported versus expectations, is at an all-time high since it began in 2003. Both indicators suggest that despite financial market volatility since mid-May, ‘Abe-nomics’ is working.
However, PM Abe’s third arrow, reform, is not going to be as easy or quick to implement given he has not been overly specific in his communication of the reform agenda. With the Upper House election now out of the way, Abe-san now has the mandate to address the more controversial reforms, including agriculture, tax, energy and labour laws – but execution will be key.
Chinese growth could fall below government targets
If the government continues down the current path, China is likely to remain a source of uncertainty for emerging markets. Current economic data indicate that without new policy measures GDP growth in China will be at or below 6% for the rest of the year. The implication: sub 7% growth this and next year, well below the government’s stated 7.5% target.
More broadly, emerging market equities have underperformed developed equities by a further 15% so far this year. On a price-to-book basis, relative valuations have cheapened by 25%. In addition to rising idiosyncratic risks such as the violence in Egypt or the protests in Turkey and Brazil, a more fundamental change has been the state of funding in emerging markets.
The investment view
- Against a backdrop of diverging Central Bank policy, uncertainty in markets is likely to continue. Developed equities remain attractive compared to bonds, and we favour minimum volatility as the preferred implementation strategy for developed market equities as it provides cushioned access to the market. Within the developed equity theme, selective European equity exposures – such as Germany and the UK – also look attractive based on valuations and positive growth signs.
- The need for income persists, and in fixed income we continue to favour credit over duration – high yield offers the best relative value. Investment grade corporates retain strong fundamentals but with their high interest rate volatility risk, access is best achieved through interest rate hedged strategies. In equities, dividend strategy remains a core theme: markets outside the US offer more attractive opportunities.
- Japanese equities, currency-hedged, should continue to outperform as the economic data improves driven by the reflation theme.
- As emerging market equities continue to under deliver, consider the risk/reward characteristics of minimum volatility and dividend strategies. For single country convictions, Taiwan and Korea are more positive stories.