Outlook for the rest of the year: limited synchronisation

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Equity markets have struggled this year, faced with economic and geopolitical headwinds. We continue to anticipate gains driven by stronger corporate earnings. Surprisingly, bond yields have stayed low, despite better economic conditions. They may stay low for a while yet. In this interview, we ask William De Vijlder, vice-chairman of BNP Paribas Asset Management, and chief economist Joost van Leenders of our Multi-Asset Solutions team about their views on the global economy and markets.

In 2013, we saw economies diverging, with the US recovering and Japan growing strongly, but the eurozone emerging slowly from recession. Has growth in 2014 been more synchronised between the world’s main economic zones?

Joost van Leenders (JvL): I think that is partly the case.

The US economy had a difficult first quarter as it was hit by severe winter weather, but has bouncing back nicely since. The eurozone recovery from recession has continued. So in terms of direction, growth in these large blocks is now more synchronised. One important factor they have in common is less austerity – the drag on growth from government spending cuts is less. Of course, the US is further ahead in the economic cycle than the eurozone. Investment has recovered further in the US and unemployment has already fallen substantially. In the eurozone, the unemployment rate is just starting to stabilise and business investment is still low.

Japan had strong quarters early last year, but growth slowed in the second half. The short-term direction of the economy is being driven strongly by the consumption tax hike in April. This boosted consumption in the first quarter, but should be a drag on demand in the second quarter. The economy could strengthen again later this year since low unemployment should allow wages and business investment to improve. But I would not say that Japan’s cycle is synchronised with that of the US or Europe. China’s economy historically has a low correlation with the US or the eurozone and this year is no different. Growth has slowed, but appears to be bottoming now. This slowdown affects other emerging economies more than stronger growth in the US and the eurozone. But the first-quarter dip in the US and the very gradual improvement in the eurozone may also have impacted emerging market growth.

How do these growth differentials affect financial markets?

William De Vijlder (WDV): The economic cycle is an important factor in our asset allocation. Not only directly, but also through its effect on monetary policy and earnings. Indeed, developed equities have outperformed emerging equities so far this year. Japan’s equity market has strongly underperformed, although this is also due to disappointment about the failure of the ‘Abenomics’ programme to make progress on structural reforms. At this point, we are neutral in our regional equity allocation. We think emerging equities are favourably valued, but we would want to see more evidence of growth recovering before going overweight. We like European equities now that the economy is improving, we see room for higher margins as sales start to grow and valuations are relatively favourable. But we believe European equities are also the asset class most vulnerable to developments in Ukraine, hence our neutral position.

William mentioned monetary policy. Is there divergence here too?

JvL: Well, monetary policy is still extremely stimulative in most parts of the world. But yes, the US and UK central banks are closer to normalising policy. The Federal Reserve has been tapering its pro-growth asset purchases steadily in USD 10 billion steps and there are no signs this will change. Fed chair Janet Yellen has said that rate hikes may follow as soon as six months after the end of the asset purchase programme,so that would be in the second quarter of next year. Looking at the growth outlook and labour market dynamics, this looks reasonable to us. The Bank of England may hike rates even sooner. Inflation in the eurozone is far below the ECB’s objective, so the ECB announced a package of reflationary measures in early June, including cutting the refi rate, opting for a negative deposit rate, no longer sterilising earlier bond purchases and providing additional loans to banks. Mario Draghi also made it clear that if they felt it necessary they would do more but I think large-scale quantitative easing remains unlikely at the moment. In Japan, I see no other option for the Bank of Japan but to keep buying government bonds. Since the fiscal deficit won’t be closed soon and the government pension fund will probably rotate from bonds to equities, the central bank must buy these bonds to prevent yields from rising.

In recent years, monetary policy has been a major driver of financial markets. Is this set to change?

WDV: I think this is already changing. Just look at the Fed. The decision to start tapering caused some unrest, especially in emerging equities and currencies. But the Fed’s game plan is clear: reduce asset purchases gradually, assess the impact on markets and the economy and start hiking rates, most likely towards the end of the second quarter of 2015. With this plan laid out, markets no longer assess every data point in terms of their effect on monetary policy. So, instead of weak data being positive for markets because they could lead to additional stimulus, weak data are now negative and strong data positive. And markets are now actually coping quite well with the Fed’s tapering. Emerging markets were underperforming before the tapering started as GDP and earnings growth weakened.

The Bank of Japan may actually increase its asset purchases later this year to weaken the yen further and push up inflation. This should support equities, which typically gain as the currency falls. Looking at the bigger picture, it is clear that monetary policy is instrumental in holding down bond yields and keeping risk spreads on ‘peripheral’ eurozone government bonds to emerging and corporate bonds contained. This is unlikely to change soon, in my view.

Finally on China: the views here range from positive, with reforms changing the structure of the economy and driving growth, to negative hard landing scenarios. What is your view here?

JvL: I think the chance of a hard landing is fairly small. Of course the economy has structural problems such as an outsized dependence on investment and credit growth. But it also boasts a high savings rate, large foreign exchange reserves, low government debt, a closed capital account and a banking system still under government control. Even defaults are tightly controlled by the government and will be tolerated only gradually to induce a better pricing of risk, particularly in the bond market. But a gentle growth slowdown looks inevitable, even if structural reforms are implemented.

WDV: Indeed, even a gradual slowdown would have an impact on markets. Demand for commodities would slow, limiting the potential for price gains. It could also affect emerging market equities, although this must be assessed case by case. It would be more negative for commodity exporters, but could be positive for commodity importers. Suppliers of intermediate goods to China could be insulated insofar as the end products are exported to the industrialised countries. But recent months have shown that increased granularity is needed when investing in emerging markets, something I do not expect to change soon.

 
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Joost van Leenders

Portfolio Manager, Multi Asset Solutions, CFA charterholder

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