Member Article

Market outlook: normal service will be resumed

Richard Clark and Simon Patterson, private bankers at Barclays Wealth and Investment Management in Newcastle, look at the current trends impacting global investors.

The uncertainties facing investors seemed to be resolving into a single question, namely: is recovery all just the result of central bank support, or is there some substance behind the stock market’s rally? That question is being addressed a little sooner than we’d thought as the Federal Reserve (Fed) has pushed interest rate expectations up, but our conclusion remains the same: normalising monetary conditions will eventually prove more of a strategic headwind to bonds than stocks.

Quantitative easing and interest rates

The Fed’s comments were focused on quantitative easing (QE), but were always going to have an impact on interest rates. Long-term rates are affected directly: QE has helped keep bond prices high and yields low. Short-term interest rates, however, are also being affected, despite the Fed’s own guidance suggesting that they see rates staying put through 2014. The rise in long-term rates has been so pronounced that it has pulled the front end of the yield and swap curve higher with it, and forward interest rates for late 2014 have risen sharply, to the extent that they are more or less pricing-in a policy move.

Normalisation

As noted, worried economists will argue that higher rates will de-rail the US and global economy. We’re optimistic they won’t. Usually, the correlation between interest rates and growth is positive: cause-and-effect runs from the economy to interest rates, not vice versa. The current situation is admittedly complicated by the range of emergency measures that have to be unwound (“unconventional” QE alongside “conventional” low interest rates). It is also complicated by the extent of the loosening that has occurred (the Fed has bought $2 trillion of bonds already, and the Fed funds policy rate at 0-0.25% is at its lowest in our working lifetimes). But this argues for a gradual, well-signalled normalisation, not a dramatic one. The Fed, after all, is not planning to stop buying bonds overnight – and the Bank of England, the Bank of Japan and the European Central Bank have not signalled any normalisation as yet.

Policy normalisation has long been the biggest obstacle we’ve seen in the road ahead. Recurring fears of a US double dip, euro implosion and/or a crash landing for China’s economy have seemed overstated, but we’ve always thought investors would need to address the monetary question at some stage. The economic forecasts may not show robust growth, but they do show the global economy – and within it, the key US economy – continuing to avoid stall speed.

Investment conclusions

Gold is particularly vulnerable as we transition to monetary normality. Many investors own it for its perceived ability to guard against the more inflationary – and dollar-debasing – consequences of QE. That ability, and those risks, have been overstated, and gold – which carries no yield – is exposed as a result. Most investors’ holdings of gold should be in the low single digits as a percentage of their investment portfolio.

In the short term, stocks are, of course, vulnerable too. We’ve long preferred developed markets (on which we’ve been tactically overweight), but we’ve been no lower than neutral on emerging equities. Our Tactical Allocation Committee has been discussing possible setbacks for several months, but has so far sat tight. Stocks remain the least expensive of the big asset classes: prospective PE ratios remain materially lower than the levels suggested by profitability and the cost of funds (even allowing for higher interest rates). Emerging stocks, having underperformed since late 2010, look cheaper, but are more vulnerable to financing flows.

Fixed income likely faces the biggest headwinds

Developed stocks have been hit by the Fed’s guidance, and were overdue a correction to begin with, but the medium-term outlook for growth may be brightening and we have left our tactical overweight intact for fear of missing a likely rebound. Instead, in mid- June we cut our recommended weightings in High Yield and Emerging Market bonds to underweight, and raised our weighting in cash to neutral. We continue to advise a strategically underweight position in government bonds and a tactical underweight in investment grade credit (and cash), and remain neutral on emerging equities and on diversifying assets.

As always, we do emphasise that investing in shares is not for everyone. Their value can fall and you can get back less than you invest – if you are unsure, you should seek independent advice.

This was posted in Bdaily's Members' News section by Barclays Bank PLC .