As I consider the outlook for the year ahead I am certain that once again the predominant theme is central bank policy. The investment world is a dynamic place and each week in my weekly musings I try to touch on the most relevant developments. Therefore, I have outlined briefly below some of the key considerations with respect to the outlook for the economy, monetary policy and various asset classes over the next year:
Global Economy: Overall output is expected to be marginally higher than in 2014; the World Bank forecasts that global GDP growth will rise moderately to 3%. Domestically, the expected growth rate for the Irish economy is closer to 4%, following a strong year in 2014. The domestic outlook is heavily reliant on the actions of the ECB and the reach for yield among investors which has supported the decline in Irish sovereign bond yields to record lows. Given the high level of indebtedness across the economy and the fragile nature of the domestic banks (25% of the value of outstanding loans are non-performing and their funding profile is heavily skewed to the short term), Ireland remains susceptible to an external shock.
Monetary Policy: The BOJ is hoping to slay the deflation ogre that has plagued the economy for over fifteen years while the ECB looks set to pursue more aggressive measures in order to avoid a similar deflationary fate to Japan. Meanwhile, the Fed and the BOE have to balance the need to raise rates for financial stability purposes against the risk of prematurely removing support for what is a relatively fragile recovery. The risk is that with interest rates in the developed world still at emergency levels these central banks will have much less room to manoeuvre if another crisis hits the global economy. The easing party is not limited to the developed countries as we have seen with China and today as I write the Bank of India have cut interest rates for the first time in 20 months.
Cash: High quality cash funds are likely to earn a slightly negative return. Euro area inflation turned negative in December so the real interest rate (nominal less inflation) is flat and could be marginally positive if deflation sets in.
Bonds: Bond yields will continue to be influenced by economic activity, inflation expectations and monetary policy, as well as investor behaviour in general. Today, the 30-year German Government bond yield is 1.19%, pointing to weak GDP growth, low inflation and low short term interest rates in Europe over the long term. Bonds still form an important part of portfolios for diversification purposes but long term bonds are really only suitable for individuals near retirement looking to match the price of an annuity or as part of an LDI strategy for defined benefit schemes.
Equities: Equity valuation is in the eye of the beholder and the concept of ‘fair valuation’ is highly subjective, again a function of the market environment and investor behaviour. At current interest rates, equities do offer better relative value to bonds. Equity markets have been highly responsive to monetary stimulus over the last five years, with China providing the most recent example of how investors have reacted to the prospect of looser monetary policy. In the context of this precedent, European equities should benefit if the ECB finally takes out the big guns and starts buying the sovereign bonds of member states. However, nothing is ever straightforward with the ECB and so there is plenty of room for disappointment.
Property: Domestically, property is en vogue again as both the residential and commercial sectors have enjoyed handsome gains over the last two years. The most recent macro-financial review from the Irish Central Bank noted that initial yields for the commercial property sector have fallen to 6.5%, from almost 10% in early 2012, driven by a buoyant Dublin office market. Against the backdrop of low interest rates, the property recovery has been boosted by the influx of foreign capital, attracted by the higher yields, which could leave the market “vulnerable to a change in investor sentiment”. Investors in property funds have to be wary of the illiquidity risk.
Commodities: The game changer in the oil markets was the decision by OPEC not to cut production and in turn leave it to the free hand of the markets to dictate the price. The market is still finding that price but the futures markets are expecting prices to rise. The macro impact of the oil price decline is debatable but moves of this magnitude over such a short time period in any financial asset can be inherently destabilising; one lesson from the last crisis is that market participants can underestimate the contagion effect from what is perceived as a relatively small part of the market, think sub-prime mortgages! At the start of 2014, equity markets in China and India were among the unloved and they turned out to be star performers; 2015 could be the year gold shines as volatility becomes more normal.