Global Asset Class Strategy

Macro Outlook: Six months after the Federal Reserve signalled that it would be prepared to taper its US$85bn/month quantitative easing programme, the dust has yet to settle entirely. As we had warned prior to the taper announcement (see Thoughts On Global Bond Markets, May 20 2013), high leveIs of foreign ownership of domestic debt in emerging markets, combined with rising US yields, make the developed over emerging market economic and asset class story increasingly compelling. Bond movements over the past few years have been reminiscent of the mid-1990s, in which sudden Fed tightening pushed yields up sharply and forced major dislocations in the emerging world. While we do not envisage a 1990s-style correction for EM, our core view is that the structural growth story in EM is changing for the worse, with major imbalances from Asia to Latin America that need to correct. Fed tapering concerns are a case in point - whether the Fed is buying US$85bn/month or US$75bn/month should make little difference in the grand scheme of things, but the fact that it is causing such concern for emerging markets exposes the degree to which their economic models are vulnerable. Regardless of when the Fed decides to taper - in December of this year or in March/April 2014 (our core view) - US yields have bottomed, and will head higher depending on the strength of the US recovery.

As it stands, the Fed is still expanding its balance sheet substantially every month, while the ECB and Bank of Japan are likely to ease further going into 2014, so policy globally is not becoming substantially tighter at this stage. We assess the risks of a 'melt-up' scenario to be higher than that of a meltdown in the near-term, particularly if the Fed decides to hold off on tapering asset purchases until much later than we currently expect. The global growth outlook has improved in the past few months, in line with our constructive view, which combined with relatively liquid conditions, inexpensive valuations, good technicals (for developed markets at least) and relative lack of retail participation in equities, suggest that risk assets have further to climb. The biggest challenge to this view is our below-consensus view on Chinese growth, which is being confirmed somewhat by poor technical outlooks for China-sensitive market instruments such as copper and Latin FX.

Equities: Equities are our preferred asset class. Over the long run, we continue to favour developed over emerging market stocks, as the structural underpinnings in DM turn into tailwinds, while those of EM turn into headwinds. In fact, as the accompanying chart shows, developed world equities are breaking out technically against their EM counterparts after a brief pull back. Apart from the US, upon which we have been bullish for a few years now, we maintain our more recently-adopted positive stance towards European equities, with our bullish eurozone financials view up 8.0% since September 24, and Eurozone over US equities up 2.7% since August 15.

Developed World Powering Ahead
MSCI World Over MSCI EM Ratio (LHS) And MSCI EM Index (RHS)

Global Asset Class Strategy

Macro Outlook: Six months after the Federal Reserve signalled that it would be prepared to taper its US$85bn/month quantitative easing programme, the dust has yet to settle entirely. As we had warned prior to the taper announcement (see Thoughts On Global Bond Markets, May 20 2013), high leveIs of foreign ownership of domestic debt in emerging markets, combined with rising US yields, make the developed over emerging market economic and asset class story increasingly compelling. Bond movements over the past few years have been reminiscent of the mid-1990s, in which sudden Fed tightening pushed yields up sharply and forced major dislocations in the emerging world. While we do not envisage a 1990s-style correction for EM, our core view is that the structural growth story in EM is changing for the worse, with major imbalances from Asia to Latin America that need to correct. Fed tapering concerns are a case in point - whether the Fed is buying US$85bn/month or US$75bn/month should make little difference in the grand scheme of things, but the fact that it is causing such concern for emerging markets exposes the degree to which their economic models are vulnerable. Regardless of when the Fed decides to taper - in December of this year or in March/April 2014 (our core view) - US yields have bottomed, and will head higher depending on the strength of the US recovery.

As it stands, the Fed is still expanding its balance sheet substantially every month, while the ECB and Bank of Japan are likely to ease further going into 2014, so policy globally is not becoming substantially tighter at this stage. We assess the risks of a 'melt-up' scenario to be higher than that of a meltdown in the near-term, particularly if the Fed decides to hold off on tapering asset purchases until much later than we currently expect. The global growth outlook has improved in the past few months, in line with our constructive view, which combined with relatively liquid conditions, inexpensive valuations, good technicals (for developed markets at least) and relative lack of retail participation in equities, suggest that risk assets have further to climb. The biggest challenge to this view is our below-consensus view on Chinese growth, which is being confirmed somewhat by poor technical outlooks for China-sensitive market instruments such as copper and Latin FX.

Equities: Equities are our preferred asset class. Over the long run, we continue to favour developed over emerging market stocks, as the structural underpinnings in DM turn into tailwinds, while those of EM turn into headwinds. In fact, as the accompanying chart shows, developed world equities are breaking out technically against their EM counterparts after a brief pull back. Apart from the US, upon which we have been bullish for a few years now, we maintain our more recently-adopted positive stance towards European equities, with our bullish eurozone financials view up 8.0% since September 24, and Eurozone over US equities up 2.7% since August 15.

Developed World Powering Ahead
MSCI World Over MSCI EM Ratio (LHS) And MSCI EM Index (RHS)

In emerging markets, the outlook is bleaker, and our bullish views on equity indices are few and far between. The break lower in the MSCI Emerging Markets Latin America index this year marks a fundamental re-pricing of regional equity markets, and we believe that a break back above long-term trendline resistance is unlikely in light of slowing economic activity and the normalisation of US monetary policy. While we like some stories in emerging Europe (including Romania), we see major weak points in major markets such as Turkey. In Asia, we have adopted a bearish view towards the Sensex, India's benchmark equity index. In China, equities look weak technically, which we believe could be sign that the bounce in economic activity will fade before long. Both the Shanghai and Shenzhen Composite indices have seen critical support break in recent weeks, and given the predictive quality of equity markets in China, this helps support our downbeat growth stance in 2014. South East Asian equities bounced back strongly from their August rout, but once again look weak and we believe that another large sell-off could be around the corner.

Fixed Income:We expect US treasury yields to trend higher over the coming weeks, driven by strong economic activity and improving labour market dynamics. The near-term risk is that the Federal Reserve emerges with more dovish rhetoric and policy than we expect, but over the medium run we think that yields are too low given the fundamentals and will head higher. This will continue to put pressure on EM fixed income where spreads remain tight.

Still Well-Behaved
US 10-Year Treasury Yield (%)

Indeed, emerging market debt holds little value, in our view, and with foreign ownership very high in many cases, most bond markets will take their cue from the US Treasury market. Following a period of looking undervalued in the wake of Fed taper talk in Q313, we are no longer bullish towards Asian local debt as recent gains have met our expectations and markets such as Indonesia are beginning to look overbought. Our regional outlooks in Latin America and Europe are mixed; for example, we envisage interest rate expectations picking up in Mexico, but declining in Russia.

Still Too Little Risk Priced In
EMBI Plus Spread

Currencies: Taking a multi-year view, we continue to believe that the US dollar is set for a bull run, which began back in August 2011. The US dollar continues to appreciate on a broad trade-weighted basis as seen in the accompanying chart, and while it is set to rise further, there is likely to be a divergence in performance between commodity-related FX and undervalued Asian currencies.

Dollar Remains In An Uptrend
US Trade Weighted Broad Dollar Index

Among EM regional currencies, Asian FX has the best opportunity for upside in both the near and medium term. Most Asian currencies are supported by strong external balance sheets, and have relatively strong economic growth prospects, which should support further relative gains, even if the US dollar were to embark on a major comeback. Asia FX outperformance has been particularly pronounced versus Latin America FX, as the latter typically suffers harsher sell-offs during times of risk aversion due to high external deficits. Although any bounce in EMFX in general would be highly likely to see Latin America FX outperform in the near term, as these currencies are generally more volatile, the medium-term picture still favours Asia FX outperformance. In emerging Europe, we see little potential for FX appreciation over 2014, with the main risk to this view being much looser monetary policy from developed state central banks, particularly the ECB.

Asia Is The Best Of A Bad Bunch
Asia FX Index Versus JP Morgan EMFX Index
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