Risk assets such as stocks and corporate bonds have further to run in 2014, even as a global tide of easy money slows, according to the BlackRock Investment Institute’s 2014 Investment Outlook.
BlackRock has released its 2014 investment outlook, entitled “Squeezing Out More Juice”.
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BlackRock is the parent of iShares, the world’s largest provider of exchange-traded funds (ETFs).
The outlook, “Squeezing Out More Juice,” considers key factors—such as the gradual exit from quantitative easing in the United States, tentative signs of a weak European recovery, Japan’s growth plan and China’s reform agenda – and their potential to create upside surprises or unforeseen downside risks.
“2014 is the year to squeeze more juice out of risk assets,” said Ewen Cameron Watt, Chief Investment Strategist of the BlackRock Investment Institute (BII). “But investors should be ready to discard the fruit when it starts running dry.”
The BII introduces three investment scenarios for 2014 against a backdrop of low nominal growth and monetary policy choices driving markets. Low for Longer, the base case with a 55% probability, features tepid economic growth and loose financial conditions.
The bull case (25%), Growth Breakout, has growth accelerating and liquidity gradually tightening. The bear scenario (20%), Imbalances Tip Over, highlights the many things that can go wrong.
Is Monetary Policy the Panacea?
Developed economies should accelerate in tandem for the first time since 2010, the BII noted. However, a key worry is that global central bank policies geared towards stimulating growth might now be “pushing on a string.”
“Low nominal growth cannot be solved by monetary policy alone,” the BII said.
“Monetary growth does not address skills mismatches, aging populations, labor market red tape and protectionist policies. Central banks can ease some of the pain – but ultimately policymakers must deliver structural reforms to boost growth.”
The Hunt For Effective Diversification Heats Up
Under BII’s Low for Longer scenario, real rates and overall volatility will stay subdued, and market momentum could easily propel equities higher. However, a fundamental problem for stocks is that prices, not earnings, are now driving returns.
“Investors have jumped on the momentum train, effectively betting yesterday’s strategy will win again tomorrow,” the BII noted. “Rising correlations between bonds and stocks are making well-diversified ‘safe’ portfolios riskier than they appear.”
As a corrective, the BII counsels investors to consider other diversification tools, such as alternative investments, market neutral funds and strategies for “hard” assets such as infrastructure. “The illiquidity of some of these approaches appears a fair price for uncorrelated returns in a low-growth world,” the BII said.
Europe Restrained by “Monetary Corset”
Fiscal austerity and aging populations will keep European growth sluggish, with southern Europe continuing to groan under a heavy debt load and struggling to regain competitiveness, the BII believes.
“Europe is stuck in a monetary corset,” the BII said. “The European Central Bank knows the Eurozone needs a weaker currency to export its way out of debt and import some inflation, yet the euro is rising due to a current account surplus and reduced financial risk. The likely result is more monetary easing – despite German opposition.”
The BII is “cautiously bullish” on European equities. Valuations are relatively low, especially compared with US peers, and companies could notch 8 to 10 percent earnings growth in 2014 based on new order trends. One caution: European blue chips are highly geared toward emerging market demand, the BII notes.
In the US, Housing and Equities Markets Face Key Risks
In the US, growth will accelerate to around 2.5 percent, and then stay there; the Federal Reserve will taper lightly but will keep rates low, the BII projects. “Tapering aside, 2014 will still be the second-most accommodative year in US monetary history, after 2013,” the BII said.
Two markets challenged by policy change in the US are housing and equities. “The taper-induced hike in mortgage rates slowed down home sales and price gains – even though housing affordability remains near its highest level in decades,” the BII said. “What happens when the Fed exits its quantitative easing program in earnest?”
In the equities markets, many investors are “reluctant longs,” the BII said, and US equities look expensive by most valuation metrics. “Corporate profits are at a record share of output, with the wage share at a low,” the BII said. “This speaks to troubling trends of growing inequality and weak wage growth – and brings into question how sustainable these margins are. Compliant credit markets are funding equity withdrawal-for now.”
The BII expects that fixed income opportunity in 2014 will continue to evolve away from a reliance on declining interest rates into an asset class where returns are more driven by the relative value between individual bonds.
International equities in many cases now offer more compelling value, especially Japanese and European stocks, BII said.
Japan’s “Three Arrows” for Growth Face Obstacles; China’s Reform Efforts Could Spark Asian Bull Market
The BII describes itself as “split” on Japan’s future, with the possibility of “either very good outcomes – or very bad ones.” Japan’s recipe for growth, Abenomics, “might actually work,” the BII notes, boosting the world’s third-largest economy, but there are real impediments to the plan’s “three arrows” – monetary stimulus, fiscal stimulus, and structural reforms.
Efforts to attain long-term fiscal health could be particularly challenged. “Any attempts to chip away at Japan’s debt load could tip the economy back into recession,” the BII said. “And if the economy takes off and rates rise, spiralling debt servicing costs would break any expansion and could even trigger a debt crisis.
“Our bottom line: There is juice left in the long Japanese equities/short yen trade – but the risks are high.”
China’s reform blueprint – which includes freeing up interest rates, liberalizing the RMB currency, and allowing land ownership in rural areas, the biggest wealth transfer in history – appears encouraging, and could set the stage for a multi-year bull market in Asian equities. “The key is whether policymakers actually follow through on their promises – volatility may be high until we see some evidence,” the BII said.
Bulls and bears agree Chinese GDP growth is slowing, the BII noted, and the debate has shifted to how much further it will fall. “A little slowdown is good, especially if it involves a rebalancing toward a consumption-led economy,” the BII said.
According to the BII, the “dragon” is not likely to “crash land,” but there are worries about credit growth. “History shows rapid credit expansion usually ends in tears.” the BII said.
A summary of the BII’s investment recommendations for 2014:
Big Picture
· Helicopter View: We generally prefer equities over bonds, particularly in our base case Low for Longer scenario.
· Risk in Safety: Equities and bonds are becoming more correlated. This is making “safe” portfolios a lot more risky.
· Alternative Menu: Infrastructure, real estate and other alternatives are real diversifiers – and offer attractive yields in a low-rate world.
· Volatility on Sale: It is better to buy an umbrella before the rain. Volatility is cheap and many assets are expensive.
Equities
· Equity Value: Equities are not cheap – but they are not (yet) in bubble territory. We generally favour Europe and Japan on valuation.
· Yield Caution: US yield plays will wrestle with tighter liquidity. Dividend growers still offer potential, as do non-US dividend payers.
· Emerging Idea: Our contrarian idea: Overweight emerging stocks vs. developed. Be selective and favour indirect exposures (multinationals).
Fixed Income
· Carry On: Many bonds still look expensive and risky (especially government debt). Go for carry or yield in a barbell strategy.
· Curve Plays: Low rates support short maturities. Tapering fears have hammered many long-term bonds back to reasonable valuations.
· Beware Traffic Jams: Easy to get into, tough to get out of. Liquidity could dry up fast in some credit markets – when you need it most.