Developed markets, emerging markets and interest rates

Markets expect that cyclical improvement in global growth this year will be led by better performance in developed markets (DMs), as Europe exits recession and the US suffers reduced fiscal drag, and there’s the broad view that the excess of growth in Emerging Markets (EMs) over DMs will be narrower than hitherto, and likely than it has been for the last several years. But it’s not as if DMs and EMs are that homogenous – with DMs, growth prospects vary from the US, now in the fifth year of recovery, with the Federal Reserve reducing its commitment to quantitative easing; here in the UK, the Bank of England may face a steepening yield curve in the face of seeming improvement in growth even as it seeks to tether cash rates low; Japan’s central bank seems likely to need to do more to ease policy and deliver monetary stimulus to offset looming fiscal shock; Euroland and the ECB must wrestle with still weak economies bedevilled by very high unemployment. The one unifying feature may be that the prospects for financial stability or instability likely rest heavily on inflation remaining relatively low but not too low, and not moving up sharply, with economic growth remaining at a pace that does not generate expectations of a rapid pick-up of inflation or return to deflation.

The cyclical outlook is made less certain by the prospect that potential GDP growth rates appear to have come down nearly everywhere, and this is linked to demographic developments and relatively weak private and public sector capital investment at least since the financial crisis. Meanwhile, the financial crisis led to extraordinarily low interest rates, and what would once have been seen as extraordinary policy measures, which have in turn led to imbalances and dislocations in and between economies which can be seen to have created a new set of risks.

On top of the cyclical and structural issues, there are a range of tactical factors, including uncertainties as to the nature of recovery in the US and the UK, and material fund flow and carry trade challenges for EMs, and with specific regard to EMs, investors are clearly worried about the risks of contagion and the extent to which DM stability and recovery might be put at risk. Certainly back in the late 1990s, Fed Chairman Greenspan commented with regard to the emerging market financial crises of that era that “it is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.” Arguably Euroland is presently the most vulnerable DM, given that its economic recovery is not well established but thus far, stress in emerging markets is probably having only small effects. As for the US, whilst there’s a lot of optimism on the back of the GDP numbers, as the January data cycle commences with ISM surveys and jobs data, commentators may become less gung-ho, supporting Fed forward guidance, or feel reinforced in their bullishness, leading to a market challenge of Fed guidance.

But the rates market is not only leveraged to DM domestic conditions but also EMs, with Treasuries likely to benefit from their role as the negatively correlated asset class to risky assets if EM conditions deteriorate further.  Our view is that thus far, developments in EMs have been relatively idiosyncratic and not indicative of broader structural issues, but negative sentiment can be sufficient to create a self-reinforcing spiral between financial flows and sentiment. This may prove to be particularly true if defensive tightening by EM central banks takes rates to levels that slow global growth.

For equities, in the near term, strong payroll numbers in the US next week could soothe market nerves, but we do need to see stabilisation at least of conditions in China for market confidence to be assured. Some commentators are looking for early policy easing by the ECB on the back of weaker-than-expected German inflation data, but this view is risky given that the weakness in inflation was mostly due to energy, forward inflation expectations remain well anchored, and both survey and hard growth data don’t suggest a need for immediate action.

For the UK, we project rate formally for the next three quarters and we expect no change to the Official Rate, at 0.50%, and modest but significant shifts up along the curve, with gilt yields at end Q3 of 0.8% for two years, 2% for five years, 3.05% for ten years and 3.8% for thirty years.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla