Central bank policy risks are bigger than ever moving into 2014, writes James Klempster, portfolio manager at Momentum Global Investment Management.
Despite moderately improving conditions in the developed world, there remains an extraordinary level of central bank sourced liquidity in the market, which brings along a whole set of risks.
There will be unintended consequences: misallocation of capital, zombie company instability through the search for yield, asset bubbles, politicians easing back on much-needed reforms, implicit protectionism, as well as the possibility of inflation down the track. Many of these results are to be seen in emerging markets today.
Policy risks are bigger than ever. The reaction of bond markets to Ben Bernanke’s initial tapering talk came as quite a shock to the Fed and shows just how easy it would be for central banks to lose control of markets if policy is mishandled. Clearly, a significant rise in bond yields would be damaging to growth and neither the US nor the global economy is robust enough to withstand such a shock.
Central bankers must not drop the ball
If we look back five years, most of us would have expected inflation to be more of an issue against the background of the money printing that we have seen. But so far, inflation is the dog that has not barked.
The question is whether the inflation we have seen to date, namely in financial assets, will at some stage spill over into the real world. To the extent that asset bubbles are created, there is a clear risk broader inflation will eventually emerge.
But we do not see evidence of too many asset bubbles around the world. Many equity markets are still below their pre-crisis levels and, in several cases, below their levels of 12 or 13 years ago. Valuations do not appear too stretched or unsustainable, other than isolated sectors.
It looks likely central banks will continue to take risks on inflation and financial stability for a long time yet. There will be some withdrawal of stimulus next year as the Fed begins to taper, but it will do so gradually.
At the same time, the Bank of Japan will continue to prime the money printing pumps and the ECB, which has plenty of room to ease further, will certainly not wish to see any tightening of monetary conditions across Europe. Interest rates are set to remain very low for at least two, probably three, years.
With this background, it is reasonable to expect the gradual recovery we are seeing in the US, eurozone, UK and Japanese economies to continue to make modest progress next year. In the US and Europe, there will still be fiscal headwinds but the rate of fiscal tightening will reduce. With the recovery underway in the housing markets in the US and UK, consumer confidence and spending will be boosted.
Investment spending is also showing some signs of recovery, with business confidence indicators in the US, UK, Europe and Japan all pointing upwards.
This means we have a continuing benign environment for equity markets.
Valuations are not as attractive as they were mid-last year but, in most markets and sectors, they are not at anything like extended or bubble levels. There is plenty of room for further appreciation as the profit environment remains supportive. It is unlikely we will see the big returns of the past year or so but returns into low double digits seem to be attainable.
The non-equity component of portfolios remains much more difficult. Safe haven government bonds remain poor value. Treasuries will need to see at least another 1% rise in yields before they offer anything approaching reasonable value; even then, they would not necessarily be cheap.
Credit and high yield still offer opportunities, as there are pockets of good value. But low yields are pushing investors into increasingly risky and illiquid securities. Corporate bonds, especially those at the lower end of the credit spectrum, do not provide protection when we most need it. We all remember 2008, when only treasuries provided true diversification and significant positive returns when virtually all other markets suffered severe falls.
Earlier this year, we shortened duration of our fixed income portfolio substantially, to be less exposed to interest rate risk, and invested in floating rate instruments to give us protection. We retained a significant position in convertibles, recognising the implicit exposure to equities but also the relatively good value.
Within equities, we have maintained a blend of managers with exposure to complementary style factors, value, momentum and quality, so we reduce the risks of underperformance as a result of sharp shifts in style preferences. Finally, despite the fact it yields virtually nothing, we have kept some cash as it provides absolute protection and gives us firepower to invest as and when markets go through a period of falling prices.
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