Six Themes Driving Asset Markets This Year

1. Easy Money: Most industrialized economies’ policymakers continue to operate accommodative monetary policies. This is bullish for risk assets generally. The Fed’s switch to QE3 as Operation Twist expired at the end of last year came with rising Treasury Inflation-Protected Securities (TIPS) breakevens, in contrast to the first two quantitative easing programs (QE1 and QE2) where inflation expectations were falling. This highlights the degree to which Fed policy has become fixated on unemployment rather than deflation risk. This is bullish for risk assets since it implies easy money for a more extended period. It is less helpful for core rates markets, however, since ongoing reflation is likely to generate better growth and higher yields later in 2013.

2. Changing Macro Correlations: The relationship between equity markets and government bonds stopped being simply a risk-on, risk-off (RORO) trade-off when the Fed capped longer-term yields under Operation Twist and then gave explicit guidance on rates — first with dates and then with unemployment rate targets. However, we think bond yields can rise later in 2013 as real GDP growth accelerates and note that nominal GDP growth has been higher than bond yields for some time. Furthermore, Fed guidance is a double edged sword. Forward rates are well below FOMC projections in the medium term implying a re-pricing in rates markets is a real risk at some point. Another correlation that is changing is the one between equities and commodities — the result of the end of the China credit-induced real estate boom. Excluding the 2010-2011 period which looks to have been an aberration, the medium-term correlation between commodities and equities is low. This implies lower returns/ allocations to commodities than to equities, but that some allocation may again reward investors aiming for diversification. Finally, in foreign exchange (FX), the US dollar tends to be weak during risk-on periods or in periods of easy Fed money. This is still the case but the beta is falling because the US dollar is relatively underpinned both by easy money being provided in most other countries at the same time as the US and by US economic outperformance.

3. US Economic Outperformance: By the standards of past upturns, the US economic recovery has been poor. But compared with other developed regions, the US recession was shallower, the rise in GDP from the trough was steeper and the Citi forecast through early 2014 shows a widening divergence to real GDP trends in Europe and Japan. This is bullish for US equities relative to other developed markets, although Japanese stocks may do well in the short-term, boosted by Bank of Japan easing. We think this will also mean underperformance by US government bonds as bear steepening, when long-term interest rates rise more than short-term interest rates, leads to a bigger rise in US yields this year than elsewhere. On FX, it’s a tougher call. As stated earlier, risk-on periods are normally bearish for the US dollar as US investors push assets overseas and there is no problem for foreign investors to finance US assets. But if US Treasury yields climb higher in the latter half of 2013, this may change the way the US dollar behaves.

4. China Stabilization: China has not announced a huge policy stimulus to attempt to return to the 10-12% peak growth rates of 2010-11. But the economic data is stabilizing roughly around a 7.5% trend, which is helpful for equities in emerging markets for a few reasons. First and most importantly, because tail risks around a China collapse are significantly reduced, and second, because the absence of an infrastructure-intensive boom in China is less bullish for commodities and therefore less of an inflation concern for emerging market policymakers. Also, China seems happy to see the US dollar/ Chinese yuan exchange rate move lower in FX markets and this has tended to lead to appreciation in other Asian currencies.

5. Emerging Market Policymakers Response to QE: Easy money in developed countries tends to mean a weaker US dollar vs. emerging market currencies. With both growth and inflation pressures lower than in the second period of quantitative easing (QE2), emerging market policymakers may resist a strengthening of their currencies in varying degrees by either cutting rates, not raising rates, or by intervening. This latter option tends to be hard to fully sterilize and therefore raises local liquidity and boosts local asset markets, including equities and real estate. We see this thesis as potentially bullish for both emerging market local rate markets and for emerging market equities.

6. Equity to Outperform Credit: Last year US equity and credit returns were similar, but credit volatility was much lower and, as a result, Sharpe ratios (a measure of risk-adjusted performance) were higher. We don’t see this being repeated in 2013. For one thing, we think equity valuations are not rich at current levels, but credit ones probably are. For another, there is a convex relationship between credit spreads and equities: the lower spreads go, the less scope they have to fall and to match future equity market upside. Forecast total returns are further dented by the expected back-up in US Treasury yields. But, most importantly, we see evidence that corporate leverage is rising again as firms use cheap debt issuance to raise cash, which they then return to shareholders in the form of dividends and/ or buybacks.

Based on these drivers, in the near term, we are bullish all risk assets and think both equities and credit will do well. Investors who have benefited from low volatility credit funds will likely take a while to be persuaded to return to equities, where uncertainty in returns appears higher. Initial equity flows may be into high dividend yield funds, which have been performing well. In the medium term, we do expect equity outperformance over credit to become more marked, partly as risk-free yields also tend to rise. We suggest reducing credit allocations to neutral and most developed government bonds to underweight (except Bunds and Gilts). Our commodity price forecasts also suggest taking commodity exposure to underweight from neutral over this horizon and raising cash.

 Authors: Jeremy Hale,