6 themes for 2015

1. This is still a banking crisis – Follow what the banks do not what they say

While the initial casualties of banking sector insolvency have either recovered (in the US) or are recuperating (in the UK), don’t be duped into thinking the banking crisis is over – far from it. Loan loss provisioning within the Eurozone remains inadequate and capital remains scarce. We view the recent European Central Bank asset-quality review as a missed opportunity to highlight this and believe that the weak capital position of the European banking sector will condemn the Eurozone to deteriorating money supply as the banking sector continues to rebuild its balance sheet through retained earnings.

The fragility of the banking sector isn’t just confined to the struggling economies of the Eurozone. There are growing concerns that much of the capital allocated to the China growth story has been misallocated and that could spur a wave of loan losses, which will see the epicentre of crisis move from the west to the east.

2. The failure of the Fed – The unintended consequences of QE3 have significantly damaged the recovery

It is also clear that in maintaining its Quantitative Easing programme long after the US banks were effectively recapitalised, the US Federal Reserve has effectively trapped stimulus in the financial system. The major beneficiary of QE3 has been the corporate sector which has used cheap refinancing rates to boost share buybacks and special dividends. Low debt default rates have also prevented the expected increase in capital expenditure and investment that should normally drive economic activity. This suggests the corporate sector has become the main blockage in the monetary transmission mechanism.

The evidence that QE has benefitted the real economy is poor given the sheer scale of the endeavour. What it has done is inflated asset prices, driving both the S&P 500 Index of US equities and bond issues to record levels.

3. Expect Eurozone QE – But rising Eurozone funding rates

The US recovery has been fuelled by the support of three factors; extraordinary monetary policy (QE), fiscal forbearance and a recapitalised banking system. Thus far, the Eurozone has had none of these pre-conditions: the European Central Bank (ECB) has avoided implementing a politically-charged QE programme, fiscal policy has been tight and disjointed across the region and we believe the European banking system remains materially undercapitalised. Against this backdrop, and with a worryingly weak growth and inflation outlook, it seems inevitable that some sort of QE-like programme will be launched in Europe, which could be positive for equities but may see borrowing rates actually increase from here.

4. Yuan devaluation – Chinese economic slowdown will force a competitive devaluation

Chinese capital continues to be allocated to state-owned enterprises over owner managed businesses which is creating a disjointed and increasingly unstable economy. The country’s excessive debt consumption linked to local government infrastructure investment is in danger of unravelling. The weak global economy and reduced competiveness suggests that authorities may be forced to devalue the yuan.

5. Secular stagnation and the risk of ‘lowflation’ – Oil price weakness is just one symptom of weaker world growth

Secular stagnation is a condition of negligible or no economic growth in a market-based economy. We believe that many of the current conditions of the world economy show signs of secular stagnation. While QE has increased the wealth of the few – increasing the developed world savings rate - this is to the detriment of investment. Only the inappropriate and excessive debt fuelled Chinese investment cycle has kept world growth afloat. Weak commodity prices and the collapse in the price of oil are symptoms of this phenomenon. The consequence will be lower terminal interest rates (the ‘new normal’), weak inflation and lower-for-longer bond yields.

6. Follow Central bank liquidity not economic activity - In a world of low growth, monetary stimulus will be the major driver of asset returns

We believe that the growing divergence between Central bank policies will be the key determinant of asset price performance. QE cessation in the US, allied to modestly rising interest rates and high valuations, will prove a challenge for US equities. Japanese QE will continue to support equity prices. Eurozone QE is now widely discounted reducing the immediate impact but, if linked with looser German fiscal policy, could drive Eurozone equities sharply higher. Chinese stimulus will sustain mainland Chinese equities but do little to alleviate structural economic issues. We expect the dollar to remain strong against most major currencies with the yen, euro and yuan all likely to devalue.

In conclusion, we go into 2015 cautious on US and Emerging Market equities, neutral on the UK but positive on Europe and Japan with an important caveat; you need to hedge the currency risk for the yen and the euro, ideally into US dollars but failing that, into sterling. We are strongly negative on commodities and have zero weighting in managed portfolios. In bonds, we are structurally overweight on high yield, and are more constructive on investment grade, although we remain underweight relative to our long-term neutral position.