With the confirmation by the US Senate this week of dovish Janet Yellen as the next Chair of the Federal Reserve and the recent commencement of tapering down of the Fed’s bond-purchasing programme (QE), investors might well ask whether or not central banks will continue to be a major driver of markets in 2014 as they were during 2013.
Fed policy and speculation over its future actions were key influences on markets during 2013: its asset purchase programme depressed bond yields, enticed investors into riskier assets and helped supercharge returns on developed market equities. Since the Fed first floated the prospect of a potential reduction in its QE programme last May, this has led to an unprecedented backup in 10-year Treasury yields and prompted a bout of extreme volatility in emerging market currencies and securities.
Now that tapering has commenced, markets are at last set on a pathway towards normalisation where fundamental factors such as company results, mergers and acquisitions, and strategy should have a bigger influence on stock prices than they have done in recent years, a period in which policy actions have driven the direction of markets.
However, it would be wrong to dismiss the on-going importance of Fed decision making during 2014. We see the coming year as a period of transition which could see further bond market volatility as expectations of changes in the yield curve develop and the dollar strengthens. The Fed will need to tread with care as a clumsy exit from US QE could prompt a global re-pricing of risk, potentially renewing pressure on emerging market currencies, bonds and shares.
While the US stock market has taken the onset of tapering and the clarity it brings well (so far), it is important to recognise that the US equity indices are at record levels and on a cyclically adjusted P/E basis, stocks look expensive.
Yet the pace of the US recovery is modest, not rampant, and real earnings growth is quite fragile. While the fiscal squeeze in the US should ease during 2014 providing a more supportive background, in recent years much of the earnings growth of the S&P 500 has come from the benefit of ultra-low refinancing costs, not innovation or sales growth. With bond yields on the rise, the best of those days look over and earnings will need to start playing catch up with share prices.
In our view, the better opportunities during 2014 might be where the taps of stimulus remain turned on, or may commence at some point, over those where such measures are being gradually withdrawn. That means we continue to favour Japan, which is currently engaged in a process of doubling its monetary base, and Europe, where anaemic growth and the prospect of deflation is piling on the pressure for further stimulus measures. For now the European Central Bank is refraining from such actions while asserting it is ready to consider all available instruments.
In the case of Japan we prefer funds that offer share classes that hedge the currency, since aggressive monetary easing could lead to further yen weakening at a time when both sterling and the US dollar may strengthen.
Highly rated Japan funds which hedge the currency include GLG Japan CoreAlpha Equity I H GBP, JO Hambro CM Japan B H GBP and Morant Wright Sakura Hedged GBP.
Top rated European funds are Threadneedle European Select Opportunities, Baring European Select, Henderson European Focus and Schroder European Alpha Plus.