In these early stages of 2015, it is interesting to think about what the global investment landscape looked like this time last year, and what we have experienced since. Despite an often turbulent market environment, it is not obvious to us that there has been a material change in the underlying fundamental picture for the global economic outlook over the past 12 months. However, something that stands out to us is that there appears to have been a meaningful shift in investor beliefs.
At the beginning of 2014, our perception was that the consensus view was one of improving global growth prospects. This seemed to be based on the assumption that the rest of the world would follow the strengthening recovery in the US economy. As such, expectations were that real interest rates, especially in areas such as the US and UK, would rise sooner, rather than later, and that the trend in bond yields would be upwards. However, although US momentum remained relatively strong throughout 2014, people now appear to be increasingly concerned that outside of the US there are structural impediments to global growth. And this means that the consensus now believes interest rates are likely to stay lower for longer over the next few years.
Reasons for optimism
So, has anything happened in the past 12 months to suggest there is justification for being less optimistic about the global economic outlook? We do not think so. In fact, we believe the observable fundamental evidence suggests that our outlook should be more rather than less optimistic compared with this time last year.
We tend to agree with the apparent consensus of most economists that it is not unreasonable to expect growth of around 3% this year. Broad longer-term trends in economic data for many regions – even those that have had some short-term disappointments recently – have continued to point to gradual expansion. Furthermore, some of this short-term weakness in the non-US data means we can observe a waning appetite for fiscal austerity, while the lack of inflationary pressures also leaves policy-makers free to pursue growth stimulation. For example, Japan has already cancelled a planned tax hike and China has announced infrastructure spending packages, while there is growing anticipation that the European Central Bank will soon be prompted into further stimulus measures, including full quantitative easing.
There has also been a very significant development in recent months that could achieve much of the work policy-makers have been attempting, in terms of providing a meaningful boost to growth. We are yet to see the significant benefit of the collapse in the oil price feed through to firms and consumers. Of course, commodity producers, such as some emerging markets, will suffer from the falling oil price, but our view is that this should otherwise be a huge net positive for the global economy in aggregate. We believe the significant slide in commodity prices (see figure 1), combined with very low interest rates, will far outweigh some short-term weakness in certain regional data points in terms of the world economy, and particularly, of Western economies.
So, if fundamentals look fine, what has been behind the market turbulence that characterised the fourth quarter of 2014? Well, for a start, we believe the market has been somewhat confused about the implications of the falling oil price – initially perceiving it as bad news for equities and good news for bonds. This was partly behind the market movements we saw over the first half of December, in particular. But another interesting observation is that there has been significant divergence in economic trends around the world towards the end of 2014 (see figure 2).
Data in the US and UK has continued to be on the strong side, but there have been disappointments in Europe, Asia and Japan, in terms of GDP growth. As a consequence, we see central bankers around the world doing very different things, with China and Japan easing while the US Federal Reserve has signalled that interest rates may have to rise in 2015. One result of divergent monetary trends has been increased volatility in currency markets – with the US dollar appreciating against most currencies (see figure 3), especially those where policy has been easing – causing some stress in financial markets.
Volatility itself has broadly risen in recent months (see figure 4) and some of this has looked quite ‘behavioural’, in our view. There were two particularly notable points – during mid-October and mid-December – where many risk assets suddenly became cheaper for no evident fundamental reason.
We think the ability of central banks to ease monetary policy could be one reason that, despite this pick-up in volatility, most markets (equities, credit, bonds) actually rose over the fourth quarter of 2014. In fact, most asset classes saw positive performance over 2014 as a whole. This raises some important considerations.
In the M&G Multi Asset team, our starting point is always valuation. At the cornerstone of our investment process is the question: what is in the current price? So when we find ourselves at the start of a new year observing that yields have broadly fallen across all assets since this time last year, we have to ask ourselves: where does that leave us today? For us, the important point to note is that while most assets are not as cheap as they were 12 months ago, not all are now ‘expensive’.
Although equity valuations have moved a long way in the past 12-18 months, the shift in investor sentiment that suggests a lack of belief in genuine, sustainable global recovery means equity risk premiums continue to provide attractive compensation for equity growth risk versus perceived ‘safe’ assets. As a result, current equity valuations are generally still not expensive relative to historical norms – while bond yields, which have fallen even more in the main, are now well below historical norms – according to our valuation framework (see figure 5). So, although opportunities exist in selected equities, particularly relative to bonds and cash, patience is required in waiting for certain factors to play out.