December-January 2014

OUTLOOK: 2014: If we are lucky…

Europe...the crisis-hit countries of the developed world will see some economic growth. But political risk and unemployment will continue to frustrate the recovery. George Mitton examines what strategists in the funds world expect for the coming year.

House prices have risen in the US and, at the same time, households have paid down their debts. Corporate earnings are also at record levels. In Europe, the threat of a sovereign default seems a distant risk. Globally, stock prices have rallied to pre-crisis highs. Dare we whisper it? Is this finally the end of the financial crisis?

“That’s the 64 trillion dollar question,” says Willem Verhagen, senior economist at ING Investment Management. “The honest answer is we won’t know until well after the fact. But I think the probability is rising.”

With a few exceptions, the consensus view is that America is leading this recovery. It is commonly forecast that the US will achieve growth of 3%, perhaps even more, in 2014. Just as a collapse in the American financial markets triggered the global collapse, so will a resurgent return from the world’s capitalist superpower pull us all out of quagmire.

That, at any rate, is the optimistic view. But look elsewhere in the world and there are less encouraging signs. In Europe, for instance.

First, the good news. The European periphery has become more competitive. The corporate sectors in Spain and Ireland have paid down debt and are in a positive financial balance. Even Greece, the hardest hit in the eurozone debt crisis, whose bonds were not so long ago commanding yields of more than 30%, has posted some fairly impressive growth figures lately.

The performance of these countries has led some in the “core” countries, such as Germany, to proclaim that the eurozone has fixed its problems. But is it so?

The great worry is unemployment, which is high across the eurozone but disastrous in the peripheral states, especially among the young. How comforting is it for a Spanish teenager to be assured that the eurozone has turned a corner, when they and more than half their peers cannot find a job?

“This is a massive problem,” says Verhagen. “The risk for these economies is that the cyclical slump will inflict permanent scars on potential output, because people move to other parts of the euro area.”

Although in one sense it is desirable for unemployed youths to move countries to find work, because it helps rebalance the eurozone, in another it is damaging; if these so-called peripheral countries permanently lose a share of their workforce, they will struggle to repay their sovereign debts.

The sad thing is that many economists believe it didn’t have to be this way. If the eurozone had not forced countries like Greece and Spain to implement structural reforms and severe fiscal tightening at the same time, but had budgeted for a longer recovery period with reforms and tightening in sequence, the eurozone might have avoided high cyclical unemployment and the resulting social unrest.

Can Europe, despite these challenges, follow the pace set by the US and complete its recovery? There are plenty of optimists out there. The Eurostoxx 50 index has risen nearly 20% in 2013. The markets seem to have been reassured by the outright monetary transactions (OMT) programme, which is perceived as providing the final liquidity backstop for the European states.

Yet there are still reasons for caution. The apparent desire of the European Central Bank (ECB) to do “whatever it takes” to save the eurozone has not been tested, and cynics point out that the ECB’s promise comes with a pretty big caveat. What Mario Draghi actually said was that the ECB would do whatever it takes within its mandate. Whether full deployment of the OMT programme is deemed to be within the ECB’s mandate is largely a political question.

This, then, is the problem with trying to predict the economic recovery of Europe: politics always gets in the way.

And whether or not you are optimistic about Europe in 2014 depends largely on whether you think European policymakers can put aside their political differences and agree on a shared policy.

Some economists are sceptical. They say despite its rhetoric, the ECB has not intervened enough to restore EU-wide growth. They are concerned that the ECB will continue to be hamstrung by the reluctance of the core countries to accept a rise in inflation.

“We have an EU-wide unemployment rate of 12% and the trend in core inflation is nearly a percentage point below target,” says Verhagen.

“If these numbers were to apply to the US, the Fed would be throwing everything including the kitchen sink at the problem.”

There is another spectre looming over 2014: tapering. Markets went haywire in the summer when US Federal Reserve chairman Ben Bernanke, who stands down in January 2014, hinted that the Fed would begin reducing its bond purchases, thus winding down its quantitative easing programme.

The shock was so great that the Fed was forced to backpedal and delay the start of tapering. When tapering finally begins, will we see a repeat of the summer – a spike in bond yields and a deterioration of emerging market assets?

Some analysts believe not. The prevailing view is that markets misinterpreted the threat of tapering – and are unlikely to make the same mistake again. “Tapering does not equal tightening”, is a phrase currently doing the rounds. If enough people believe it, the market reaction to tapering could be fairly benign.

So if tapering is not a threat, it is nothing to fear? In fact, say many analysts, they should be happy when tapering finally happens.

“The developed economies are in the intensive care unit,” says Jean-Sylvain Perrig, chief investment officer at UBP. “That’s not a normal situation. If you’re in the intensive care unit, you have one idea, to get out. Otherwise it means you’re finished.”

According to this logic, investors should welcome the start of tapering, because it indicates that the US economy is recovering well. The start of tapering does not signal a clean bill of health, though. Once the drip and the oxygen are removed, the patient can expect to be a little short of breath and perhaps unsteady on her feet.

“But let’s remember the patient is not being asked to leave the hospital. Doctors will coomtinue to administer aid in the form of low interest rates and continued quantitative easing, though at a slower pace.

Perhaps, despite all the common sense about tapering not equalling tightening, there will nevertheless be a negative market reaction.

It could happen.

But what does seem likely is that next time around, it will be a reaction after the event. There are some in the markets who believe the Fed got its fingers burnt by announcing tapering before actually doing it; the negative reaction was so great, the Fed was unable to action its policy. Next time, they say, the Fed will surprise us.

So, if the market has collectively decided that tapering is not as bad as it thought it was, does that mean emerging markets will be less badly hit than last time? It’s hard to find a consensus on this.

Some investors are optimistic, saying emerging market assets suffered a brief correction and are already recovering.

“When we look at emerging market fundamentals, it hasn’t changed,” says Vincent Juyvns, global market strategist at JP Morgan Asset Management.

“Even the weaker countries remain pretty good, far better than the fundamental situation of most developed countries. Tapering might generate some volatility but the fundamental story is we can still rely on emerging markets.”

It seems a convincing story. After all, the factors that drove a decade-long enthusiasm for emerging market investing – rapid industrialisation in countries such as China, the creation of a large middle class with disposable income, low debt-to-GDP ratios – are still there. Surely one correction should not signal the end of an era for an entire asset class? Yet, this is precisely what some others say.

“I think we have a secular shift,” says Perrig, of UBP. “The trend will be for money to go out of these markets to developed markets. Emerging markets are still overweight in portfolios, generally speaking. It’s a thing of the past.”

Perhaps the most that can be said about emerging markets is that it is prudent to wait until the onset of tapering before piling in, and that it is important to be selective.

The current account balance in the likes of India and Indonesia is unfavourable, whereas China, with its massive currency reserves, is in a far better position to defend its currency. Emerging market investors need to choose among these different options with care.

Where does that leave the 2014 forecasters? The general view is that the US will do well in 2014, Europe will have to work harder for its growth and emerging markets will have to wait and see.

If those forecasts seem a little vague, Funds Europe apologises. But it’s best to remember this about economists: they’re better at explaining the past than predicting the future.

©2014 funds europe