Much of the nervousness in the US, Europe and Japan can be attributed to bouts of uncertainty about central bank policy direction, especially in the US via the new Janet Yellen-led Federal Reserve and in Japan post the recent sales tax increase. The periodic twitchiness over geo-political frictions in the Ukraine were also an issue. The latter has the potential for shorter term shocks, but it's the former which will have the biggest effect on the market.
Initial statements from Janet Yellen were interpreted - wrongly - by markets, as suggesting that interest rate rises were on the cards earlier than expected, possibly by as early as 2015. Initial market falls were arrested when Ms. Yellen made what one strategist referred to as "one of the most dovish speeches I have ever read from a Federal reserve official". To quote from coverage of the speech in the WSJ:
Ms. Yellen said Monday the U.S. economy and job market are still far from healthy, and still require plenty of support from the central bank’s low-interest-rate policy. The unemployment rate currently stands at 6.7%, well above the 5.2%-5.6% range that Fed officials see as normal. Annual inflation is running just above 1%, well below the central bank’s official 2% target.
“The U.S. economy is still considerably short of the two goals assigned to the Federal Reserve by the Congress” of low and stable inflation and maximum sustainable employment, Ms. Yellen told a conference on community investment. She pointed to several aspects of the labor market that suggest it continues to operate well short of its potential.
So the implication is that under the Yellen chairmanship, rates will be held "lower for longer" until such time as unemployment levels have fallen substantially below the previous target of 6.5%.
All of this is good for markets in that it implies that monetary policy, as managed by an ever accommodative Federal Reserve will remain loose for as long as needed. When you combine this with similarly loose rhetoric from the heads of the ECB and the BoJ and QE in its various forms seems destined to be with us for a while.
So whay then have markets proved jittery in recent weeks?
Its partly down to geo-politics and the uncertainties caused by ructions in Ukraine which sits astride important oil and gas pipelines for Western Europe. This seems likely to continue for a while, but we think will begin to have a diminishing influence as both sides slip into a pugnacious stalemate.
More of an issue though is that markets rallied so strongly in 2013, and the perception that valuations were beginning to look stretched at a time when earnings expectations are being revised downwards. Without earnings growth, markets remain dependent on continue re-rating for further advances.
Having said that, on the basis of the latest quarterly market commentary market valuations don't actually look that stretched at all: the S&P500 is still at an 8% discount to its long term average, and less than half the top of its historic valuations range. The same applies for pretty much everywhere else, with the possible exception of ASEAN.
That said, there are areas of market excess: the Russell 2000 mid cap index appears to be on a PER of about 62 x earnings, whilst NASDAQ looks similarly stretched. The latter has fallen by nearly 8% since this years peak in early March as earnings have disappointed.
Despite these probably justified declines, we don't think there is too much to get overly concerned about, largely because of those accommodative central bankers. With a "lower for longer" interest rate mantra, the outlook for equities - partly by default, we admit - still looks positive, and this year it may possibly be the moment for Asian and Emerging Markets to recover a bit of lost ground, simply because although tapering in the US may be an ongoing fact, interest rates aren't budging for a while.
Another chart from JP Morgan highlights the valuation gap that opened up in 2013:
We have a relatively balanced allocation between the US, UK/Europe and Asia/EM in our equity portfolios, with the balance being accounted for by fixed income. The latter two asset classes have outperformed a bit so far in 2014, and we expect this to continue.
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