Oracle: In for a googly?

Kerry Craig

Luckily I was able to attend the recent Test Match between England and Sri Lanka at Lords, and my attention could not help turning to the current state of investment markets.

Coming into the stumps at the end of the first half of the year, investors’ are still worried that markets will bowl them a googly. The papers are full of scary headlines, whether it be the flare-up in Ukraine/Russia tensions, Middle East unrest, the possibility of earlier-than-expected interest rate rises or some other event.

However, much like Gary Ballance’s 104 at Lords, investors should steady the nerves by reminding themselves what has been keeping markets afloat this year.

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Uncertainties undoubtedly still abound, but overall the risks in the macroeconomic environment have ebbed significantly. The eurozone is in an extended period of relative calm and the European Central Bank has finally taken much needed action.

In the US, headwinds such as the ‘fiscal drag’, are fading and after the weather-distorted first quarter, economic growth should build throughout the year. Meanwhile, UK growth has exceeded expectations to such an extent that the Bank of England is spelling out to markets that the first round of interest rate rises might come sooner than expected. And in China, the latest economic data points towards an economy that is beginning to stabilise.

While the big macro risks may have abated, it would be remiss to discount the more nuanced risks that still threaten to knock off the bails. Looming large in the corridor of uncertainty is the current low level of volatility. At this point in the economic cycle low volatility is not unusual, but investors should bear in mind this environment will not last forever.

So how is the wicket shaping up for the remainder of the year? I see three stumps which will support a modest overweight to risk assets through 2014.

First, monetary policy remains highly accommodative. Central banks slashed policy rates in the developed world as they tackled sub-trend economic growth. The ECB has eased policy and may take more action this year, if Mr Draghi is to be believed. Similarly, the Bank of Japan will continue with its astronomical bond-buying scheme.

Even if rates do start to rise, it is likely to be a very gradual process in response to an improving economy rather than an attempt to cool an overheating one. Rates rising from this very low level should therefore not harm equity markets.

The second stump is closely associated with the first. The reason we are unlikely to see a sharp rise in rates any time soon is because inflation remains relatively benign in the developed world. Low levels of inflation have historically been supportive of price-to-earnings multiples, which suggests a cautious overweight to equities is warranted.

Finally, the global economy is actually improving. Forward-looking indicators that are closely correlated with growth, such as purchasing managers’ index data for the manufacturing sector, are rising. This suggests global growth is strengthening, which should translate into higher revenues and corporate earnings expansion.