Diverging economic and monetary policy developments on both sites of the Atlantic Ocean
- Euro area: economic growth suffers from lack of reforms and geopolitical conflicts
- Central Banks: Fed starts rate hikes in 2015, ECB remains expansive
- EUR/USD: dollar remains in upswing
- Global equity market not (yet) in a period of exaggeration
- Asset allocation: equities remain the more attractive investment form
"Due to the subdued leading indicators and the ongoing conflict between Russia and Ukraine, we had to significantly lower our forecast for the total economic growth in the euro area since our last forecast in June from 1.2 to 0.8 per cent for 2014 and from 2.0 to 1.6 per cent for 2015.
In the US, on the contrary, above-average growth for the next two years is more or less certain. Therefore, the development of the inflation rates is quite different. While the inflation rate in the US is expected to increase from currently about 2 per cent towards 2.5 per cent, the rate of price increases in the euro area will be below 1 per cent for most of the coming year. In this scenario, significant deviations from individual countries, like for example Germany or Austria, are seen," starts Valentin Hofstätter, Head of Bond Market & Currency Research at Raiffeisen Bank International AG (RBI) the presentation of the fourth quarter "Strategy Global Markets".
While geopolitical tensions have intensified since the summer, they are only marginally responsible for the disappointing development of the economic data in Europe so far. First and foremost, it is the lack of willingness to embark on reforms in several countries, primarily France and Italy, and the insecurities and more cautious outlook of companies, which is mainly causing investment in plant and equipment to lack behind. "It has to be pointed out in this context, that the most important export destinations of the euro area, especially the US, show an improving growth dynamic. Therefore, the current export declines to Russia due to the economic sanctions are manageable. However, a further military escalation and/or a blanket trade embargo could make the euro area slip into recession," Hofstätter comments on the conflict between Russia and Ukraine.
Central Banks: Fed starts rate hikes in 2015, ECB remains expansive
The experts of Raiffeisen Research are still expecting that the US-Federal Reserve (Fed) will have to continue to tighten its wording regarding the timing and the extent of the upcoming key rate hikes. Currently they do not see their expectation, that the Fed will increase the key rates well before mid-2015, sufficiently factored in the bond prices. In combination with the improving economy, this will also lead to a significant yield increase (and respective price decline) for US government bonds. This price decline in US government bonds is a temporary argument for the attractiveness of equities. On a more long-term perspective, though, government bonds will then offer higher yields than pure dividend yields from US equities.
"Although at the beginning of the year a stronger growth for the euro area was expected, the European Central Bank (ECB) managed with its statements and later announced easing measures to set essential impulses. We expect the ECB to continue to support the liquidity environment that benefits the stock markets. In the US, the positive economic growth data will lead to a different development. Until far into 2016, we do not expect the ECB to weaken the easy access to liquidity nor to increase the key rates," analyses Hofstätter further. Therefore, the price for short-term Euro-bonds continues to be well supported, while long-term Euro-bonds will see a negative impact with falling prices from the US bond markets throughout the course of 2015.
EUR/USD: dollar remains in upswing
The yield differential between German and US 2-year government bonds - a reflection of the different outlook on the key rates - continues to be the main determinant of the development of the exchange rate EUR/USD. Since mid-year, the yield differential has extended in favor of the USD.
"For the next few quarters, we expect the current divergent monetary policies of the Fed and the ECB to continue and even intensify. With increasing key rates in the US the yield for 2-year government bonds will also continue to increase. Due to the latest measures of the ECB, short-term interests in the euro area have practically no upside potential. Hence, a logical consequence would be a further devaluation of the Euro against the USD in the coming months. For end-2014 we presume an exchange rate EUR/USD of 1.26. For the course of 2015 we are currently expecting a rate EUR/USD of below 1.20," says Hofstätter.
Global equity market not (yet) in a period of exaggeration
The excess liquidity of the past years, which was initiated by the low key rates and quantitative easing of the central banks, is a main driving force in the "search for yield" that nowadays leads some markets commentators to warn from a burst of the bubble. In fact, the European government and corporate bonds market seems already expensive given the extremely low yields. But one may not forget that this extreme is a reflection of the current macroeconomic environment that anticipates low growth and marginal inflation for a longer period of time.
The situation is different for equities. Here, the argument for an exaggeration is backed by the fact that the NYSE, measured by the nominal GDP, is already participating in a similar degree in the stock market rally with debt capital like back in 1999 and 2007. Also, the issuing activities on the stock markets have significantly increased. In this context, the mega IPO of the Chinese online trader Alibaba can be seen as a warning signal. Globally, a strong year for IPOs can be expected, although the current levels are still far from former record years. The global volume for M&A activities has recently noticeably increased due to favorable funding conditions and tax loopholes, but is also considerably below the volumes of the booming years.
"An argument against an exaggeration is still the moderate evaluation of the equity markets. The global benchmark MSCI World is only slightly above the historical average and hence significantly cheaper than in former highs of the cycle. The attractive evaluation of the European equity market in comparison with its US counterpart needs to be highlighted. The dividend yields of large European stock indices of 3 to 3.5 per cent are still higher than the yields of corporate bonds in this investment grade. But also other markets like Japan or most Emerging Markets are not overly expensive," opens Veronika Lammer, Head of Quant Research and Emerging Markets at Raiffeisen Research, her outlook on the development of the global equity markets.
The profit development of European companies benefits from the weakening of the Euro and the simultaneous decline of the oil price. In combination with the expansive monetary policy of the ECB this should lead to an outperformance. But also investments in the US equity markets remain interesting due to the dynamic domestic growth development and the estimated currency gains from the expected strengthening of the USD.
„In summary, we think one cannot yet talk about a general exaggeration on the equity markets. But it seems likely that the upward trend has already reached its mature phase and strong correction periods may temporarily occur," continues Lammer.
Mixed picture on EM equity markets
"The Emerging Markets (EM) are showing a mixed picture. While the Indian SENSEX had the best performance amongst all emerging countries with a value appreciation of 36 per cent (local currency basis) since the beginning of the year, the Chinese stock market suffers from the weak economy of the People's Republic. In China, the room for gains is limited, although historically seen the valuation still seems favorable with a PER of 7.5 and an expected gain of 5.1 per cent for 2014," begins Lammer her overview of the EM equity markets.
In Brazil, the fourth quarter will bring a landmark presidential election that could pave the way for urgently needed structural reforms. The current profit margins of the BOVESPA of 7 per cent and the PER of 17.8 are historically seen and in comparison with other EM little attractive. Over the next few quarters, investors also have to take higher currency volatility, due to the expected key rate hikes in the US, into consideration. In case the presidential elections do not lead to a substantial strengthening of the current investment climate, the BOVESPA is very likely to quickly react with price losses.
Asset allocation: equities remain the more attractive investment form
"Our portfolio for the fourth quarter of 2014 remains unchanged with 53 per cent in the equity segment, 42 per cent in the bond segment and 5 per cent in real estate," explains Lammer. The reasons for the overweighting in the equity segment are the still moderate pricing of the equity markets, the further monetary easing in the euro area as well as the expected ongoing improvement of the economy in the US and Europe.
"Within the equity segment, we continue to focus on Europe and the US, but also Japan and selected EM. Within the bond segment, we have reduced the share of European government bonds in favor for US government bonds, which together still account for more than half of the entire portfolio. In addition, we suggest mixing in CEE government bonds, Eurobonds and euro corporate bonds," ends Lammer.
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