Despite the odd wobble, the US economy continues to thrive. Employment remains robust, household wealth is on the rise and the housing market is strengthening.
Even allowing for the occasional bump in the road, a reasonable forecast is for average US annual growth of about 3 per cent over the coming three years. Our own economy is similarly hale. Unemployment is forecast to tumble from 6.2 per cent this year to 5.5 per cent next year, while GDP is expected to come in well above 3 per cent, making the UK the fastest growing G7 economy in 2014.
Meanwhile, Abenomics has already succeeded in jarring Japan’s economy from two decades of slumber with the Topix index rising more than 50 per cent in the five months following the implementation of the new policies at the end of 2012. An increase in sales tax this year may have delivered a painful contraction in GDP last quarter, but it is clear that Japan’s leadership is committed to keeping its nascent recovery on track.
In contrast to the world’s other mature, consumer-driven economies, Europe continues to drift. And, after more than five years of extraordinary monetary policy in the US and UK, the gap between Europe and its peers has rarely been wider. This growing chasm resulted from the way in which each responded to the financial crisis in 2008. September saw the sixth anniversary of the Lehman Brothers collapse. The largest corporate bankruptcy in history marked the start of very different paths for the US, the UK and Europe.
The US and UK quickly adopted a systematic approach to shoring up their banks and recapitalising the financial system. Banks that were beyond salvage were either allowed to fail, nationalised or put on the auction block, drawing a line under banking liabilities, even if it required private debt to be moved onto the public balance sheet. In tandem with the extraordinary monetary policy that accompanied such measures, such actions created the conditions for recovery.
In Europe, the position was quite different. With no single body empowered to take action, no consensus and no concept of a pan-European balance sheet to fall back upon, the individual economies in the region continued to flounder, culminating in a sovereign debt crisis. So while banks in the UK and US were busy reviving, many of those in Europe lapsed into coma. With no means to compare the liabilities of a German bank with a Spanish bank, for example, it was impossible to sort the wheat from the chaff. Meanwhile, those banks still in business were forced to retain capital to rebuild their balance sheets, rather than lending it out.
It has taken six years, but Europe’s big banks have now almost achieved the capital buffers required by their regulators. This means they can finally turn from balance sheet rebuilding to lending, supporting Europe’s economies in the process. Even so, while the UK completed its quantitative easing back in 2012 and the Federal Reserve will be ending its asset-purchase programme next month, we still expect to see the European Central Bank being forced to follow suit if it is to combat the threat of deflation. If Europe’s markets react in the same way as Japan’s, the results could be spectacular.
For investors, the gap between the policy cycles of the US and UK and that of Europe, presents a range of risks and opportunities. Among the most obvious risks are the carry-trades that have been fuelled by historically low borrowing costs. As the prospect of a rate rise in the US and UK draws nearer, asset classes such as high-yield bonds look increasingly vulnerable. Such concerns saw some multi-asset portfolios exit the high-yield arena in June in favour of property assets – a timely decision in light of the violent sell-off a month later. Similarly, US and UK corporate bonds are also vulnerable and investors should be sure to reduce their weightings here before a rate rise becomes reality.
The story is much the same for emerging market bonds – especially those denominated in hard currency – and for emerging market equities. Last summer’s rout of emerging markets, which was triggered by Fed rhetoric, will still be fresh in the minds of many. Higher-yielding currencies such as the Canadian and Australian dollars are also likely to suffer when carry trades start to unwind. Those that benefit will be the funding currencies such as the US dollar, the yen and the Swiss franc.
By contrast, Japan’s quantitative easing is still underway, which should continue to support local equities and maintain a weaker yen. Meanwhile, European monetary authorities must take action to avoid what’s been termed Japanification. If the ECB does unleash a significant asset-purchase programme, it should float both equities and bonds. Despite the record lows we have seen in German bond yields, for example, there is nothing to prevent them moving still lower and some managers have maintained holdings in both European government bonds and euro-denominated credit for just this reason.
Clearly, times are changing and, as always, it will be those investors that can change with them that will fair best in the years ahead.
Nick Samouilhan is a multi-asset fund manager for Aviva Investors
Key points
* The US economy continues to thrive, despite occasional wobbles.
* In contrast to the world’s other mature, consumer-driven economies, Europe continues to drift.
* Japan’s QE is still underway, which should continue to support local equities and maintain a weaker yen.
