January 2014 - A Cathartic End to 2013
Markets ended 2013 on a cathartic, yet slightly cautious note. Catharsis came in the form of the Federal Reserve’s December 18 announcement that tapering of its large-scale asset purchases would begin in January 2014. This decision, which investors had attempted to predict—albeit incorrectly—over the last twelve months, removes a significant element of uncertainty from the market and participants appear more comfortable with an end to the super-easy monetary policy in the US. Markets reacted positively to the Fed’s decision which was accompanied by "forward guidance" which made clear to markets that short-term rates would remain extremely low. Risky assets continued to move higher into the final days of 2013 with the S&P 500 up 29.6% and the Eurostoxx up nearly 18%.
Still, there was a cautious tone to the ascent as investors and analysts alike reflected on 2013, asking whether such stellar performances in developed market equities could persist. We believe that an improvement in the global growth outlook led by an acceleration in the US, should continue to support risky assets in 2014. We provide a detailed discussion of our views and high conviction ideas in our 2014 Outlook: “Transitioning from the Printing Press to Forward Guidance,” which we will release in the coming weeks.
The Federal Reserve’s announcement that it would decrease its asset purchase program by $10 bn to $75 bn was accompanied by a commitment to low rates. As we have written about previously, the Fed will use forward guidance to communicate that tapering is not tightening and that its near zero-interest rate policy (ZIRP) will be maintained. According to the Fed, ZIRP will continue "well past the time the unemployment rate declines below 6.5%." As expected, yields on the U.S. 10-year treasury moved towards the 3% handle.
We forecast that U.S. 10-year Treasury will trade between 3.25 and 3.50% by the end of 2014.
In the euro area, financial conditions continued to ease as sovereign debt among Europe’s periphery rallied into the New Year. In Spain, this was accompanied by a 107,570 decline in jobless claims in December, the largest decline in 14 years. Still, the unemployment rate remains high at 26% but below the peak of 27.2% in 1Q13. Manufacturing activity also showed signs of improvement as the euro area PMI rose to 52.7 in December from 51.6 in November. The print brought a better-than-expected outcome from Italy and Spain while the dichotomy between France and Germany continued to widen as the French PMI fell to 47.0 while Germany’s rose to 52.7
The European Central Bank will hold its first policy meeting since Latvia became the 18th euro area nation on January 1, 2014. Inflation at 0.9% in the euro area remains well below the ECB target of “close to, but below 2%”. Going forward, we do not rule out the possibility of additional non-conventional monetary expansion including another LTRO or negative deposit rates. Though funding costs for governments have narrowed, companies and financial institutions in the euro area’s weakest economies still face higher borrowing costs. This continued level of financial market fragmentation is not something the ECB will stand by on. For now, the ECB will most likely remain in a wait-and-see mode before it takes additional measures.
In Japan, the Nikkei 225 closed the year at its high, up 56.7% while the Yen continued to depreciate against the USD throughout December. Not all was good for Abenomics as Japan's 3Q13 GDP growth decelerated to 1.1 from 1.9% in 2Q13. We believe that the government of Prime Minister Shinzo Abe will not stand by should additional headwinds manifest such as falling wages or a deterioration in consumer sentiment. To help cushion against the April 2014 increase in Japan’s consumption tax to 8% from 5%, the government passed an 18.6 trillion yen fiscal package in December to spur job growth.
In China, short-term interbank lending rates--Shibor-- spiked higher in December, fueling concerns over tighter credit conditions in the country. The last time this occurred was in June 2013 amid the interbank liquidity crunch. The rise in rates may have been due to expectations that the Chinese government will take additional steps to tighten monetary policy as well as year-end needs to meet various regulatory requirements for liquidity ratios. Curbing credit growth and allocating credit more efficiently is part of a broader package of reforms which were adopted during China’s third plenary session of the 18th party congress and which will impact growth going into 2014.
In our view, equities continue to offer the highest risk premium and are the asset class least vulnerable to an orderly exit of QE. We continue to favor late cyclical vs. defensive stocks in the US and are overweight European equities on our conviction for further momentum in the euro area’s recovery.
We believe that high yield credit credit remains an attractive asset class despite the significant compression of spreads this year as a result of highly accommodative monetary policy. We believe that high yield spreads are still high relative to default rates. We are overweight European high yield through lower rated corporate bonds with an average 3 to 4-year to maturity.
A high degree of volatility across financial markets is likely to persist into 2014 and as we transition into a "new normal" of a less expansionary Fed. That is why a proper regional and sector selection strategy, combined with rigorous riskmanagement should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.