Risk assets have declined slightly from mid-November levels and bond yields continue to creep higher.
The last month brought a mixture of improving global growth data, but reaction was tempered by the expectation that the Fed would begin tapering its QE program earlier than some had expected. As the committee’s expectation of December tapering played out, it was decided to align allocations to the positive medium-term outlook by increasing the weighting of equities.
Regional preferences within equities are largely maintained with overweights in Europe ex UK and Japanese equities combined with neutral positions in other regions. The equity overweight was partially offset with an underweight in corporate bonds.
Economic outlook
Macro fundamentals in advanced economies improved through December and the committee is increasingly confident that global growth will improve further into 2014.
The committee continues to expect central bank policy to remain generally supportive and sees central bank forward guidance as a strong commitment to keep rates low and not choke off the recovery prematurely.
The Fed’s comments accompanying the start of QE tapering have confirmed this view. The rise in treasury yields is viewed as a reflection of better growth prospects, rather than posing a threat to the recovery, but a spike in yields beyond what would be justified by better growth is seen as a significant tail risk for the economy and for markets.
A US budget deal was a positive surprise and significantly reduces the risk of another government shutdown and debt ceiling impasse next year.
The compromise may not be a grand bargain, but is nevertheless a noteworthy change compared with the polarised political chaos in Washington in recent years.
Concerns about the Chinese economy continued to fade and the committee believes the structural reforms announced after the 3rd Plenum have significantly reduced the tail risk of a hard landing in China.
In the shorter term, although Chinese data surprised positively, the committee expects the delayed effects of tighter credit conditions to prevent a sustainable acceleration in China growth.
Survey data in the euro area stabilised, but the committee does not expect to see the development of the type of private sector credit cycle that is gaining traction in the US and UK.
The committee still worries about euro area sovereign debt and political risks over the longer term, even though it is difficult to identify a trigger for a fresh bout of market upheaval in 2014. The UK outlook is where the committee’s views continue to be furthest from consensus.
Most of the committee still expects Abenomics to work or for further policy stimulus to be introduced if there is any sign of faltering.
Liquidity and positioning
Liquidity conditions are expected to remain supportive for the foreseeable future with the Bank of Japan (BoJ) and ECB maintaining easing biases and the BoJ the most likely to ease further in the medium term.
Markets’ willingness to differentiate between tapering and monetary tightening reduces the negative market effect of tapering on liquidity.
Positioning has remained surprisingly neutral despite the rally in risk assets. This was attributed to the continuing inflows into equity funds and a likely reflection of most investors remaining cautiously optimistic rather than having fully bought into an equity bull market.
Equities
Global equities have drifted lower over the past month despite generally positive macro news flow.
Performance of indices over 1 month
Source: FE Analytics
This was due to both the preceding strong rally and a growing view in the market that stronger macro data meant an earlier start to Fed tapering.
The committee returned to an overweight equity allocation on the Fed’s tapering announcement, consistent with the long-held view that the medium-term macro outlook remains very supportive for equities.
On a twelve-month horizon, equities are expected to post gains roughly equivalent with earnings growth but no longer driven by re-rating. A total return of approximately 14 per cent through the end of 2014 is seen as the base case with the risks skewed to the upside.
Tail risks (China/EM, Euro zone and the unintended consequences of QE) remain a concern, but the positive cyclical outlook was expected to put a blanket over these risks for the moment.
The committee expects to add further risk via equities in a correction.
Regional preferences remain with overweights in Europe and Japan, increasing the latter over the course of the last month. The remaining regions were neutrally weighted following an upgrade to US equities.
The investment case for Europe is built on the assumption that European earnings will outgrow US earnings for the first time in three years due to greater operating leverage, lower starting margins and a larger improvement in sales growth.
The case for Japanese equities rests on the view that they are the most geared into the global economic cycle and that Abenomics will continue to deliver positive news flow.
Fixed income
Fixed Income yields rose over the past month, generally in line with the committee’s view that rates would have to normalize if global growth improved as envisaged.
Credit is seen as much less attractive than equities, especially in an environment of corporate re-leveraging, but spreads are likely to remain relatively tight.
Hence credit was downgraded to underweight to partially offset the increased equity position