19th August 2013
The expert view: Stephen Cohen, chief investment strategist for BlackRock International Fixed Income gives his thoughts on what to expect from markets for the rest of 2013.
Performance-wise it has been a weak year for fixed income, a mixed bag for equities and a truly miserable time for gold. 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 per cent for the rest of the year. The implication: sub 7 per cent growth this and next year, well below the government’s stated 7.5 per cent target.
More broadly, emerging market equities have underperformed developed equities by a further 15 per cent so far this year. On a price-to-book basis, relative valuations have cheapened by 25 per cent. 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