There has been a distinct divergence in equity markets in the past six months with the developed world moving up gradually, whereas the emerging markets have trended down.
There are a number of dynamics at play within this decoupling in markets, two of the critical drivers being the reduction in market liquidity brought about by the US Federal Reserve beginning to taper its monthly bond purchases compounded by what appears to be deteriorating growth in the world’s second largest economy, China.
Both of these factors have led to a squeeze on liquidity as capital has been withdrawn from emerging nation debt and equity markets and repatriated to the developed world, threatening those economies that rely on external financing. We also saw a material depreciation of the Chinese currency against the dollar, reversing a trend which had been in place for two decades.
We remain concerned about China’s falling economic growth and bloated banking sector, which dampens our enthusiasm to commit capital to China or areas that have been the material beneficiaries of China’s fixed asset investment boom that has flattered many markets in recent years.
This has all come about at a time when the western world appears to be in rude health, the US and UK markets, for example, having traded close to all-time highs. When looking at these markets in isolation, one would think that euphoric times were upon us.
Many speculative new age technology and biotech stocks have led markets higher in spite of, in many cases, the lack of positive earnings streams. Some of these companies may well prove to be the winners of the next decade, but pricing new-age opportunities for world domination has been seen before and the trend has historically proven to be transitory.
In our opinion, the current period of economic history is unique; we are in the midst of the largest monetary experiment our capitalist system has ever experienced and no one truly knows what the financial landscape will look like when we reach our destination. Looking at 2014, the key story is likely to be if, how and when the US authorities finally bring their monetary experiments to an end.
In our opinion, the US is set to continue to reduce monthly bond purchases, meaning that this stimulus could fall to zero in October. At this point the US economy must be self-sustaining to avoid the market falls that have typified the ends of previous bouts of quantitative easing.
Markets, and specifically sovereign bond markets, are now a battleground. Bonds have enjoyed an incredible secular bull market which has lasted for in excess of 20 years. With inflation and bond yields so low and bonds so heavily owned, investors are bound to look elsewhere for returns.
If the world economy is recovering, albeit slowly, then money is likely to gravitate towards equities and away from bonds. Risks can be seen from many quarters: a resurgence of inflation, the escalation of political problems, the emergence of emerging market traumas, further European crises or simply the economic recovery stalling.