FYI | Oct 30 2013
-US politics hold back growth
-QE conundrums
-Australian equities still favoured
-Australian growth seen subdued
-Eurozone banking issues continue
By Eva Brocklehurst
Russell Investments is forecasting modest gains for equity markets and higher bond yields in 2014. The global asset manager thinks a strengthening, low inflation global recovery should favour equities. What's the biggest risk? Short sighted politicians.
The fourth quarter Strategist Outlook & Barometer report finds US monetary policy and political pressures globally are the biggest threats to the performance across asset classes in 2014. European equities are favoured over US equities and synchronised growth is expected in the major economies for the first time since 2010. It's over five years since Lehman Bros collapsed and, if history were repeated, inflation pressures should now be growing and, in conjunction, interest rates should be rising.This time the cycle is not "normal", Russell maintains. Major economies have plenty of spare capacity and, hence, there's minimal inflation. It should be some time before tighter policy settings are justified.
The US economy is expanding solidly but the concerns of Russell's chief economist, Mike Dueker, centre on the political fisticuffs that will deliver more fiscal cuts and threaten to halt momentum. If this were not the case the US could achieve nearly 3% growth next year and job gains of 200,000 per month. The strategists have bought dips and sold rallies over the past few months and their models suggest the US equity market is near fair value. The Federal Reserve's decision to maintain quantitative easing (QE) shows how determined the chairman is to maintain supportive policies. Russell's take is that short rates will stay low for a long time, and the Fed's first rate hike is unlikely until the second half of 2015, even then the pace of change will be glacial. In this environment equities are preferred over fixed income.
The strategists think the recent fall in bond yields was overdone and the market over-reacted to the decision to delay tapering QE, as well as the US government shutdown. The strategists' models have the US 10-year yield reaching 2.8% in the first quarter of 2014 and 3.2% by the end of 2014. The criticism of QE – that there'll be a crash when the stimulus is withdrawn – is considered overblown. QE is described as pushing on a string, rather than a distortion of the market. The winding down may generate volatility but the strategists find little evidence the Fed has distorted asset prices. The money has not flowed into the means that usually trigger consumer spending. Banks have been unable to lend the funds, which have remained in reserves. The wholesale de-leveraging of businesses and households has countered the Fed's efforts to stimulate the economy.
Russell connects the fear of the end of QE to the linking of the Fed's forward guidance to QE. The Fed has caused investors to expect earlier rate rises when hinting at the winding back asset purchases. There's no link, but the messages are easily confused and this creates volatility, in the strategists' view. QE has had little influence on Russell's portfolio weighting decisions and, while conceding the future direction of Fed policy will be important for markets, the overall impact of QE is considered to be smaller than the headlines suggest.
On the Australian front, large cap equities have outperformed Australian fixed income by 23% on a total return basis over the past 12 months. The declining strength of this signal over the September quarter has been one of the largest changes to the market view, but this does not mean that Russell plans to be underweight on equities. Harvesting some profit is seen as the most prudent course. The strategists consider that this declining equities versus fixed income pattern will hold for the next 12 months, as lacklustre conditions and mixed economic signals prevail. Low interest rates that are driving house prices higher will be balanced by a slowing domestic economy as the resource sector boom eases. In other words, Australia subdued but not in recession. The strategists see value in long Australian government bonds and believe the currency remains expensive.
Eurozone equities still appear relatively cheap and capital flows continue amid the easy policy of the European Central Bank but it pays to be vigilant, according to Russell's strategists. Since the Eurozone's long-term problems have not been solved, positives only marginally outweigh the negatives. Europe's long-awaited recovery could be challenged by the failure to create a proper banking union. The banking sector review will be conducted in early 2014 and could uncover some significant capital shortfalls, which will again raise the vexed issue of how impoverished peripheral economies can re-capitalise their banks without German help.
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