Global equities and global bonds made progress in May 2014, with the former outpacing the latter in local currency terms; for the month, the MSCI World index rose 2.34% in total return terms while the JP Morgan Global Government Bond index returned 0.87%. Commodities, which prior to May had performed very robustly, lost some ground as the Dow Jones-UBS Commodity index produced a dollar total return of -2.87%. Nonetheless, returns from the asset class remain well into positive territory for 2014 to date.
Looking forward, we believe that there are three questions that investors have to consider over the remainder of 2014:
How will bonds react to the normalisation of policy in the US?
What will happen in emerging markets as policy is normalised?
Will corporate profits drive equity markets higher?
Bond markets in recent months have presented us with a conundrum – indeed we held an ad-hoc Perspectives meeting in mid-May to discuss the meaningful decline in core government yields. In the US, our expectation is that GDP growth will be in the order of 2.5% this year and that the overall macroeconomic picture is probably stronger than the Q1 GDP data would suggest. All else equal, that should push bond yields higher, particularly if the Fed stops its QE programme later this year.
The outlook for eurozone bond markets is rather more difficult to call; certainly Germany and Spain appear to have positive growth momentum, which should put some upward pressure on yields if that momentum remains in train. By contrast, the growth outlook in countries such as Italy and France remains very subdued, which is likely to keep yields low. The lack of growth in France and Italy is worrying given that debt levels remain elevated at a time when inflation in the eurozone overall is very low (just 0.5% for the year ending May 2014). The ECB has responded by cutting official interest rates to record lows and now charges banks for depositing funds. It has also outlined a new programme of Long Term Refinancing Operations (LTROs) to aid bank lending and has said that it will intensify preparatory work related to outright purchases of asset-backed securities. Whether this policy response will work remains to be seen, but it shows that the ECB is definitely not resigned to a protracted period of low inflation.
In emerging markets, we remain positive on local currency emerging market debt (EMD) in our asset allocation matrix; my colleagues James Waters and Toby Nangle have commented recently on the value offered by EMD, especially for investors seeking absolute levels of yield. However, we maintain a bias against emerging market equities as we are still concerned about the macroeconomic outlook for China (which is a large constituent of the EM equity indices but only a relatively small component of EMD indices). As I have mentioned in previous comments, it is very hard to find examples of credit expansion on the scale seen in China which have not caused policymakers some significant headaches once the bonanza has ended.
Our outlook for equity markets for the remainder of the year is positive; M&A has made a welcome return in recent months, and while this increases the risk of value destruction by company managements in the longer term (e.g. if they overpay or acquire businesses that later prove to be a poor fit), it does provide an important short-term support for stocks, particularly at a time when the Fed is tapering QE. The style rotation over the last few months has been significant, but overall equity markets have been strong and current index levels suggest that investors still have confidence in the outlook for profits. For that reason, we trimmed exposure not only to government debt but also to investment grade credit in late May, as the rally in core yields had left both asset classes looking expensive. We deployed the proceeds into Japanese equities, as the fundamentals here continue to improve while the market has lagged other developed regions over 2014 to date.