The combination of low volatility and the low rate environment created by central banks has given risky assets carte blanche as investors continue to disregard geopolitical risk in the search for higher yields. Economic recovery in the United States and to the IMF’s surprise England contrast with the struggle with deflation in Europe and falling exports in Japan.
Quantitative easing policies around the world have fed stock rallies. Low for longer continues to be the mantra of 2014. The United States Federal Reserve will end it’s tapering of its bond buying program in the fall. Chair Janet Yellen had famously hinted that rate hikes would begin “six months” after the end of tapering. This would put the first US interest rate rise in the spring of 2015.
Billionaire investor Warren Buffet has praised former Fed Chair Ben Bernanke for doing what was necessary. In this case keeping rates low to boost economy growth the benefit of stock market investors. Buffet has continuously warned bond investors as he sees them as terrible investment as the asset class has been inflated by the Fed’s stimulus.
Global equity markets have enjoyed a record high year. Developed and emerging markets have taken advantage of record low rates. The big exception is Russia that has suffered through the US and EU sanctions after its involvement in the Ukraine turmoil. It has to be said that the fall would have been much worse if major central banks had not been running accommodative policies.
Equity markets deaf to Geopolitical Shocks
Equity markets have for the most part ignored geopolitical risks. 2014 has been full close election cycles, the Ukraine-Russia crisis, Libya and Iraqi rebels as well as a flare up of Gaza violence. Public company earnings have stoked investor appetite as major indices print record high after record high. Mergers and acquisitions even in cases where both are under performing have resulted in positive stock returns in the current climate.
Fed and BOE Set to Hike, ECB and BOJ Need to Turn On The Taps
Central banks established QE programs after the 2008 crisis to inject liquidity into the system and avoid a global meltdown. Some economies have fared better than others. The US was singled out by the IMF last year for moving ahead of Japan and Europe in terms of growth. An unusually harsh winter made a big dent in the first quarter of 2014, but the US economy seems to have thawed out and is pushing ahead. The Fed was the most likely candidate of the first major economy interest rate hike until the United Kingdom overtook it in the summer.
After the UK economy recovery surprised both the IMF and even the Bank of England, governor Mark Carney sought to be ahead of the curve and there were heavy hints of a hike before the end of the year. After disappointing retail sales and flip flop statements Carney was labelled an “unreliable boyfriend” by a UK member of parliament. The Fed remains in pole position for a rate hike, but expectations are of spring at the earliest with a possible delay until mid 2015.
On the other end of the table the central banks of Japan and Europe will be forced to step in actively in the second half of the year. The Bank of Japan has so far been able to use only rhetoric, but it is running on the fumes of its massive stimulus in March of 2013 which made Abenomics a concrete reality. To counter the long lasting effect of the sales tax and the hard to visualize legal reforms the BOJ will have to step into the spotlight if PM Shinzo Abe’s goal of a Japan comeback story is to materialize.
The European Central Bank has rarified normal market dynamics that even Spanish bond yields are below US Treasurys given the default risk and eurozone breakup risks are minimal. German Bunds a destination for risk adverse investors are posting yields that were last seen before the fear of a potential Eurozone breakup. Low European yields will push the ECB into providing further stimulus. Expected actions by both the Fed and the ECB will further increase the divergence between Bunds and Treasurys.
European and Japanese equities will continue to attract investors as both CBs will continue to keep adding liquidity in order to spark growth.
In a topsy turvy world look for down under for guidance.
The Reserve Bank of New Zealand has raised its benchmark rate 4 times this year to 3.5%. It was the first of the western economies to start increasing rates. RBNZ Governor Graeme Wheeler has been optimistic about New Zealand’s growth and that of its main trading partners. The central bank has signalled that the current rate will be held for some time and most likely after the Fed makes its move in 2015. The challenge facing New Zealand and Australia is how to balance a booming housing market from turning into a bubble while at the same time keeping their currency devalued to aid exporters. All this while still having an attractive rate differential specially when compared to Europe and Japan.
The expectation down under is that the US Federal Reserve will hike in 2015 with a high probability that the US benchmark rate will finish the year at 1%. The antipodean central banks are positioning themselves ahead of a US economic recovery which would strengthen the USD and give New Zealand and Australia an exporting edge. The risk of course is if that recovery does not materialize or if the rate hikes are too sudden which could have global consequences as the IMF has warned about.
Some markets are more emerging than others
Emerging markets have weathered the storm, but fundamentals will continue to differentiate between solid performers and riskier propositions. Twin deficit countries will suffer (Brazil, Indonesia, Turkey and South Africa) while countries like Mexico and Korea can take advantage of strong economic fundamentals to keep boosting stock and currency strength in 2014.
This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.