The Chinese are said to believe it is a curse to live in interesting times.
For anyone trying to forecast markets today that is certainly true.
The long-run effects of monetary experimentation such as quantitative easing are unknown. But what is known is that policy is at the limits of its effectiveness given indebtedness and an inability or unwillingness to use fiscal tools. Against this backdrop investors should be prepared to search far and wide to generate returns.
Economic forecasts point to modest expansion in 2015, but divergence is becoming more pronounced across the eurozone, US, Japan and the UK. The improving growth paths of the US and UK are in stark contrast to the softness in mainland Europe, Japan and, relative to their potential, emerging markets.
The potential divergence in central bank policy, combined with areas exhibiting economic fragility, raises the prospect of a more challenging market environment. However this also creates opportunities for investors, as does the return of currency volatility.
Tumbling oil prices have added to the air of uncertainty hanging over markets. Brent crude fell by almost 20 per cent in December alone, reaching a five-year low of $51 a barrel. The speed of the fall caused some ripple effects in broader markets. The weakness of the commodity market remains a watch factor for those concerned about growth, or those who are focused on high yield and certain emerging markets, whose fortunes are intertwined.
Inflationary pressures are unlikely to be a destabilising force for markets in the near term. Longer term, a modest increase in inflation should be expected if employment growth continues to accelerate, and that could exacerbate the interest rate sensitivity of markets. Improving growth and the lack of inflationary pressure have fuelled strong asset price performance. But this coincided with the expansion of the Federal Reserve’s balance sheet, a programme that has now been withdrawn.
Investors should take note of significant global divergence on quantitative easing policies and monitor global financial conditions closely. The Fed and the Bank of England have curtailed their stimulus, but the European Central Bank and the Bank of Japan look set to continue, and the People’s Bank of China may also join the fray.
The degree of stimulus injected by central banks so far is without precedent, and the process of unwinding it is a unique challenge. Tightening has a habit of revealing weak links, and the tide of liquidity that was unleashed by the Fed and other central banks covered up underlying weaknesses in a number of countries.
The timing of when tightening is priced in by markets is critical. Should the current path of US economic expansion be maintained, a rate hike should be expected by June 2015 and market pricing is likely to reflect some form of tightening cycle. At the same time the ECB and the Bank of Japan will still be supplying ample liquidity to the global monetary system, so the interaction of these competing forces will be interesting.