2014 – a game of two halves?

The past six months have involved decent returns from global financial markets, and notably fixed income – following the negative returns of H2 13, the Barclays Global Fixed Income aggregate is up 4% since the start of the year and the MSCI World Equity Index is up just shy of 5%. On a risk-adjusted basis, long fixed income has delivered nearly twice the returns of equity thus far this year.
Whilst a combination of modest growth, well-behaved inflation, continued central bank easy policy and record low volatility across asset classes have proved constructive for markets, H2 2014 is likely to be more challenging especially for Fixed Interest but with the premise that it’s hard for H2 to be as helpful as H1, it looks prudent be more defensive in H2.
On the macro front, there have been scant signs of rising inflation pressures, and this has helped the Fixed Interest markets with the anchoring of yields supporting global risk assets. But now we can have far less confidence that the short-end of the US fixed income curve will remain well anchored in H2 – notwithstanding the relatively benign view presented by Fed Chair Yellen at the last FOMC meeting, US inflation pressures do appear to be picking up, and potentially significantly if recent trends are maintained. If the trend pick-up in inflation continues, we can expect core PCE to end the year at 1.9% compared with the Fed’s forecast of 1.55%. Perhaps more worryingly, fixed income investors have increasingly been looking through the US inflation data with the gap between the Fed’s forecast for the Fed Funds rate at the end of 2016 and market pricing running near 70bp – technically the largest gap between the Fed’s forecasts and the market since the Fed’s “dots” were introduced in 2012.
In terms of how we can position defensively, in the context of our mandates,

– We can increase our underweight of global fixed income, overweighting cash.
– With equities, a sustained period of rising yields should favour value stocks over growth ones, especially given the cheap valuations in value stocks, most notably in the UK and Europe.

That said, the global equity and general risk asset calls are hard for the coming months. While an increase in US inflation and the likelihood of a correction higher in short-end US yields may be disruptive for risk assets, this risk should be balanced to some degree by a scope for significant improvement in global growth in the second half of the year. Looking at the numbers, global GDP growth could accelerate markedly – from an average of c2.5% (qoq, sa) in H1 to c4.0% in H2, which would be the best six-month run in global GDP since 2010 – although 4% annual global GDP growth is far below levels seen before the financial crisis. But following nearly three years of sub-par global growth, the second half of 2014 should feel better. More importantly, as a context for the pricing of assets typically linked to the global economic cycle, equities look cheap relative to forecasts for global growth in H2.
As important as the acceleration in global growth is the composition and it looks as if leadership in growth is shifting away from the US towards Europe and China. To be fair, US growth is set to accelerate, but will still likely fall below consensus forecasts and only be incrementally more positive than in the past few years. Meanwhile, European growth, even with the recent disappointments, should provide the biggest lift to growth this year. Following a very weak two-year period, Euroland growth could average just over 1% in 2014, with UK growth even stronger. Meanwhile, China’s growth this year could come in close to the government’s 7.5% target, with perhaps 8.5% growth in H2. Importantly, any shift toward more growth leadership from Europe and China would happen at a time when asset prices linked to these regions’ growth are significantly cheaper than those linked to the US business cycle most notably US equities and to some degree US credit.
Overall, better global growth should be (just) enough to offset rising US yields as the market begins to more seriously contemplate the start of a Fed rate hike cycle. But even more so than before, we see a strong case for favouring better-valued assets outside the US. On the equity-front, from a top down perspective, it looks right to underweight US equity against EM, Asia (including Japan and Euroland. Stretched valuations make the US equity market the most vulnerable equity market to any hawkish shift in Fed policy expectations.
It also looks prudent to move to a tactical overweight in commodities, by increasing tactical (and strategic) weight to oil and copper/base metals. It looks that oil market participants and institutional investors have been lured into a false sense of security by the long period of stability in oil prices but investors could be in for a shock in the months ahead, with the sharply increased level of threat to oil output, especially in Iraq, combined with a lack of supply flexibility, leaving the global oil market more vulnerable to a supply shock than at any time since onset of the financial crisis in 2008.
Turning to credit, year-to-date returns have been surprisingly strong. The backdrop of rallying rates and low volatility has helped push spreads near historically tight levels across all major credit markets. Looking forward, it is hard to see a repeat of the H1 performance. The expectation of higher US and European yields means that total returns in credit are likely to be lackluster for the balance of the year – with likely negative total returns in IG, and small positive returns in HY and local currency EM debt. While we don’t expect rising inflation and the prospect of markets bringing forward Fed tightening expectations to be a major risk to credit, historical betas suggest that US HY and EM hard currency debt may experience some spread widening if US short end yields rise in line with our expectations.
Net-net, we hold our credit allocation broadly unchanged, but we view the next six months as a period of low total returns across the credit spectrum, while the negative asymmetries are non-negligible.