Outlook for second half: sweet with a dash of sour
In a fragile but repairing global economy, central banks will remain on alert to issue support
If policymakers across the world were to highlight the single most important challenge facing them today, likely all would identify - in one form or another - the perplexing issue of growth. Europe has too little of it; China has too much of it; Japan has none of it; and, as usual, the mighty US economy appears to have not too much, not too little, but just about enough.
The apparent fixation on growth has important consequences for investors, not least the fact that markets are driven by central banks, specifically that wily scheme known as quantitative easing, which we will just call money printing.
The push towards money printing is largely responsible for the distortions that now challenge investors.
It explains why the equity markets of most growth-poor Group of Seven nations are at all-time highs; and why the equity markets of most growth-rich emerging nations have underperformed. It explains why the lowest bond yields in the world are often linked to developed nations with the highest debt levels. And it explains why, globally, yield-rich defensive stocks (think utilities) have convincingly outperformed cyclical ones (think airline stocks).
So exactly how should investors position themselves? If we had asked the same question in the three years after the Lehman crisis, the answer would have been simple. When central banks injected liquidity, you bought; and when they eased off, you sold.
During the first half of 2013, however, things have gotten a little more complicated. There are increasing signs that the third round of the Fed's money printing is mostly going to domestic assets - such as housing - thereby boosting US growth and corporate earnings. As a result, US equities have outperformed their emerging-market counterparts.
The confidence created by money printing is as important as the easing itself; thus, success depends largely on a central bank's ability to convince the public and the market that it will support growth by doing whatever it takes, for as long as it takes.
Now it is the turn of the Bank of Japan to print money. In April, it announced its intent to inject a jaw-dropping US$1.2 trillion into the economy over the next two years. Will this lone reflation exercise - by itself - rouse Japan's economy from its 25-year slumber? Unlikely. But it is likely a portion of "local" liquidity will find its way to offshore markets.
But one person's (economic) reflation is another's (currency) debasement. Just look at the nervousness among Japan's trading partners in the face of the yen's almost 30 per cent depreciation against the US dollar since September 2012. And similarly, see how the US dollar weakened in line with the Fed's various money printing initiatives in 2008-11.
Put another way, how long can Europe stand in the way of relentless euro appreciation before someway, somehow, and at some point, the European Central Bank discovers the motivation to embark on a money printing of its own?
China's accelerated economic rebalancing, away from investment-led towards consumption-led growth, is encouraging us to become much more selective about commodities.
For example, in the decade to 2011, China was the engine that powered emerging market producers, importing up to 60 per cent of global commodities, and engineering a price bubble in the process. Decidedly slower growth in the past couple of years has seen commodity prices slump by a quarter.
So where do all these inter-connected global growth strategies leave the private investor? As ever, the secret lies in the timing. It is clear the US economy is normalising and within a couple of quarters the market is likely to come round to the view that money printing will not last forever.
Inevitably markets will become nervous and volatility may increase. But a stabilising US economy and tapering Fed should be also viewed alongside the start of Japan's aggressive reflation initiative, which in balance-sheet-to-GDP terms, dwarfs that launched by the Fed.
Admittedly, most of the liquidity generated in Japan thus far has gone to domestic markets, which is why Japanese equities have done well in the year to date. But at the point local equities are viewed as being rich, or at the point local corporates are forced to accept higher bond yields abroad, we should anticipate accelerating capital outflows and then rising prices for global stocks and credit.
Thus my "sweet and sour" outlook for the second half.
A fragile but gradually repairing global economy will ensure major central banks remain on high alert, ready to support consumption and investment though money printing. And as they have done in the past, stocks and bond markets will respond positively to such interventions.
If a difference is to be highlighted, it will be one of rotation. By asset, that rotation will be from riskless cash and rate products into riskier bonds and equities. By geography, we feel more money will flow to emerging-market assets than the first half of the year; and finally, by sector there is likely to be a rotation into cyclicals once the defensive trade is seen to have carried out its safe haven role and prepared investors for the improving economic outlook into 2014.
John Woods is Citi Private Bank's chief investment strategist, Asia-Pacific
