- Monetary stimulus from central banks can no longer be counted on to lift asset prices
- For 2014 we see a market with lower cross-correlations and more divergent investment outcomes
- Finding alpha opportunities requires in-depth global research to take advantage of market inefficiencies
While there is fierce debate on the ultimate effectiveness of monetary stimulus surging from the central banks, one cannot dispute the boost that it has given to asset prices. While we may be seeing some “green shoots” of overall growth pick-up in the developed world, the post-crisis recovery in asset values has not been primarily driven by economic or earnings growth. Instead, we have been in a high correlation environment where the rising tide lifted most diversified investor boats as repressed “risk-free” rates pushed money out into riskier asset classes. While central bank support of a still fragile global economy is unlikely to be abruptly pulled away, tapering has begun and investors may now face an environment where homogenous outcomes are a lot less likely. While overall cross-asset returns may not be as exceptional in 2014, we should still see alpha opportunities as regions, nations, industries and corporations diverge in their ability to navigate a world without the tailwinds of incremental central bank stimulus.
If central bank policy is no longer the predominant force behind market movements in 2014, what swing factors do we look to? We think investors should pay close attention to two factors for allocating assets globally: 1) global competitiveness (and resulting growth) and 2) the pace of incremental reforms that tactfully balance business friendliness with sensitivity to a global workforce increasingly conscious of income inequalities.
In the United States, we have seen increasing confidence in the general competitiveness of businesses in key growth industries supported by the solid capitalization of the banking system to finance future growth and the revolution in energy production as a major input to overall increased cost-competitiveness. On the risk side of the ledger is the lack of adequate progress around fiscal reform or entitlements, the challenges of growing profits off of a base of historically high margins, and equity valuations that, while not excessive, leave far less margin of safety than we saw at this time a year ago.
Our European team is optimistic that we will see a continuation of gradual European recovery, but on both the global competitive front and the pace of reforms, it is far from a universally positive outlook. While we are seeing signs of improvement on the margin, there is divergence between the fortunes of the most proactive reformers such as Spain and the UK and the foot-draggers such as France. However, unlike the U.S., aggregate profit margins are well below prior peaks and valuations remain fairly forgiving, leaving room for upside against that backdrop of lower expectations.
Japan, having suffered through almost two decades of malaise, has reasserted itself on the global stage with the bold economic policies that have become known as “Abenomics.” Abenomics has been described as having “three arrows”: 1) aggressive monetary easing, 2) fiscal stimulus and 3) structural reforms. Japanese markets responded extremely favorably to the competitive boost the economy has received from heavy doses of the first arrow and some small measure of the second arrow in 2013. However, the markets will increasingly need evidence of continued progress, collective will and skillful execution around implementing arrows two and three in order to sustainably drive Japan’s recovery.
This will be an important year for emerging markets, which disappointed stock and bond investors in 2013. The rise of Chinese economic might over the last two decades and governance reforms in the wake of the 1997 currency crisis helped drive significant advances across emerging financial markets. However, investor concerns about declining global competiveness and stalling structural advancements began to accelerate in 2013. Recently announced reforms in China may help to lend greater sustainability to the Chinese growth story, but the details around implementation will be crucial not only to Chinese prospects (where market valuations reflect a great deal of skepticism), but to many other nations and economies strongly influenced by Chinese demand. In the broader emerging world, we see a high likelihood of more heterogeneity in outcomes and the opportunity for diligent and well-informed investors to benefit from that growing divergence against a backdrop of valuations that reflect far greater market worry than a year ago. Sorting through balance sheet fundamentals, government policy direction and shifting competitive positions within the emerging world may be increasingly rewarding from an alpha perspective.
All in all, 2014 is a crucial year in which the recovery fueled by a rising tide of monetary stimulus must begin to be supported by accelerating organic economic growth and progress on structural reforms. Developed market economies must begin to address their fiscal imbalances while emerging markets must reassert their competitive positions in a world where Chinese growth does not float all ships and pure labor cost advantages have been eroded. Corporations must begin to demonstrate the ability to drive stronger sustained revenue growth; they must also make some tough decisions about how to allocate their significant cash positions. This wide mix of major market drivers creates quite a bit of potential variability in outcomes. However, the uncertainties arising from such a confluence of events need not deter investors. Lower cross-correlations and divergent outcomes can create opportunities, especially for those with the breadth, depth and quality of global research to take advantage of market inefficiencies. We are excited by the alpha opportunities we see being exposed as the tide begins to ebb and we look forward to the challenge of uncovering them in the year ahead.