What central bank policy can tell us about 2014

There’s a great rush of tomes on what next year will be like for investors, as if the end of a calendar year is a watershed moment for policies, economies or markets. Perhaps more interesting is a look back at what’s actually been happening with central banks continuing to provide support for both bond markets and risk assets.

In pricing assets, the broad expectation of market participants has been and remains that the Euroland debt crisis and US fiscal challenges will be contained with growth in Developed Markets continuing to improve.  Against this backcloth, central bank policy – actual and anticipated – will continue to drive markets, with particular focus on what the ECB will do to engender sustainable growth and how the Federal Reserve will push on towards policy normalisation.

Given that shifts in policy will be gradual but tapering by the Fed might be quite soon, the pre-occupation with central bank decisions looks unlikely to change for some time, but we should expect a gradual resurgence of focus by market participants on the fundamental factors of growth, corporate leverage, earnings and inflation.

The implications of central bank policy becoming increasingly long in the tooth are that equities will likely experience less strong forward progress, and be more volatile, whilst government bonds, having experienced a significant mark down in recent months should offer more resilient performance – albeit with in the context of weakening trend. Indeed there’s now a decent chance that safe-haven bond returns are not negative in the year ahead. That said, this outlook of decent equity prospects and a weakening tone to bonds suggests that investors will take increasingly more risk and through so doing, there must be a rising risk of pushing equity prices to over-valuation, with then rising risks of pronounced correction.

In shaping our thoughts for next year, we anticipate that growth will accelerate in Developed Economies, especially in the US, without at this stage threatening a shift up in inflation. However with accelerating growth, fears of central bank policy normalisation will become an increasing focus for markets, albeit that it’s unlikely that we will see rate hikes before maybe the second half of 2015. This suggests that safe-haven bond yields will rise more slowly than in 2013  and the combination of ample liquidity and a glut of global savings will fuel the hunt for yield, driving asset price inflation, as with limited growth keeping consumer price inflation benign.

We can also expect re-leveraging of non-financial companies to accelerate without becoming a drag for bond holders yet, and high yield corporate bonds may perform well under this scenario, whilst rotation from bonds to equities continues. This should in turn drive down equity volatility although there may well be a rising number of volatility spikes. What we will likely see is therefore equity out-performance as valuation multiples expand further but increasing risks of corrections within the uptrend.  This is also an environment in which prospects for commodities remain inferior to equities. With Developed Markets doing well, the longer term attractions of Emerging Markets (EM) may continue to be ignored, though buying opportunities will likely emerge in 2014.

There are risks to monitor and in particular, any pickup in inflation or central bank policy mistake may trigger anticipation of quicker normalisation of monetary policy. Equally a stronger rise in government bond yields could choke growth or cause fears of an EM crisis. Euroland also carries specific risks including the possibilities of an adverse ruling of the German constitutional court on the ESM/OMT, increased structural problems in France and Italy, and a failed return of Ireland or Portugal to the rates market. There’s also the US debt debate and politics to re-visit and the next moves on ‘Abenomics’.

These factors in the round, together with current fund flows, leave us positive on equities against fixed interest with the expectation that any de-risking and profit taking into the year-end likely offset by window dressing and positioning for the next year. Perversely for some, we’d become more cautious if bullish sentiment got progressively out of hand.

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