19th July 2013
Fund firm BlackRock has set up an Investment Institute to bring together its various areas of investment expertise to give guidance to investors away from the cut and thrust of day to day fund management. The most recent report from the recently established organisation suggests that investors should anticipate both increasing divergence in asset returns as well as a broader and more diverse range of risks.
The midyear investment outlook “Exit, Entry and Overshoot” says that global monetary policy is diverging and the era of easy money slowly ending. It says that distorted markets are resetting but could overshoot with the Fed is ready to wind down bond purchases if US economic momentum holds. It says risks are increasing, including a potential emerging market funding crunch and spike in real interest rates with increased volatility.
At the start of 2013’s, the institutute evaluated a series of scenarios for the global markets and economy for the full year, and said what it described as the “Age of Separatism” the most likely with 35% chance of happening. This scenario is marked by growing differences between economic growth, policy moves and financial market returns across all assets. In its mid-year report, BII has boosted to 40 percent the odds that “Separatism” will define the entire year.
An End for the Era of “Easy Money”
BlackRock says that central banks are taking differing policy routes, with the Federal Reserve starting to wind down its massive stimulus effort, while the Bank of Japan is planning a $1 trillion-plus monetary booster.
“We see markets resetting to levels where expectations and realities are better aligned. At the same time, the global “thirst for yield” and high cash levels are buffers against bond yields shooting up and risk assets spiralling down. “Separatism” is “good news for stock and bond pickers”, with relative value investing taking on greater importance”, says Ewen Cameron Watt, BII’s Chief Investment Strategist.
The Institute also has assigned increased odds to a “Nemesis Redux” scenario, marked by global recession, deflation, or a credit crunch, with steep losses across asset classes.
“Chances of a financial meltdown remain low, but we are raising the odds of our bearish Nemesis scenario to 15% (up from 5%) as markets will recognise the new risks,” including emerging market funding problems and yield increases.”
The BII has listed other highlights under several headings.
The Fed: The Fed has sketched out a plan for gradual QE withdrawal but made clear the pace depends on economic data. Other signposts include Europe making progress on cleaning up and recapitalising its banks, and Japan not just talking about labour market reforms and deregulation but implementing them.
Emerging Markets: Funding strains in some emerging economies are real and could get worse, but an exact repeat of the 1997-1998 Asia crisis looks unlikely. The most vulnerable countries are those dependent on external funding. This shows up in current account deficits and plummeting currencies. Disparities among emerging markets are growing fast-and so are disparities among returns. Picking the right exposure is more crucial than ever.
China: China’s economy is slowing-but those expecting a monster stimulus are probably daydreaming. If anything, China is reining in alarming credit growth. This is good in the long run, but can cause market disruptions in the short term.
Finally here are the BII’s investment recommendations for the rest of 2013:
Big Picture: Favor equities over bonds but brace for a lot more volatility. Many bonds still look expensive and risky.
Up and Down: Expect more market gyrations as policies, economies and currencies diverge.
Hidden Risks: Correlations rise in periods of market stress, making portfolios riskier than they appear.
Chemical Reaction: Beware of liquid assets suddenly turning into solid mass.
On the Offensive: Slowly move to cyclical stocks from crowded income plays and defensives. Valuations between high- and low-quality stocks are near record levels.
Structural Bond Bid: Rising rates will probably be capped by limited supply and steady institutional demand for yield. We favour the short end of the curve for now.
Emerging Bargains: Emerging equities look good on most measures except free cash flow-which matters if financial conditions tighten. Wait for currencies to stabilise before sorting through the bargain bin.
Awaiting Further Sales: Most emerging debt looks fully priced after an issuance boom brought to market risky bonds at high prices. Relative value is key.
Red Flags: Watch currencies for funding strains in emerging markets and the drivers of real rates for signs of deflation in the developed world.
Flow Flux: Bumper inflows into fixed income funds now look at risk of reversing. Investors who (mistakenly) saw bonds as money market substitutes may bail.
Dawn in Japan: Our Japan trade (buy equities and sell the yen) is still on for now. Structural reform is needed to propel Tokyo stocks much higher.