Fear of rising global interest rates could prompt equities shake-out
Unusually low levels of volatility in asset prices over the last few months are not expected to continue and investors should brace themselves for more volatility, especially if US economic data continue to improve and investors reassess interest rate expectations.
Commenting on Novare Investments’ economic report for the second quarter of 2014, Francois van der Merwe, Head of Macro Research at Novare, said the slow and steady global economic recovery was set to continue.
“Accommodative monetary policy will continue to dominate investor sentiment and liquidity will remain abundant as waning of US stimulus is taken up by renewed measures from the central banks of Europe and Japan. Major macro-economic risks have diminished, but complacency over continued easy monetary policy, especially in the US, might be tested at a later stage, and geopolitical risk may rear its head from time to time.
“Employment will be the biggest indicator for the direction of monetary policy in the US where there’s a commitment to keeping rates low to stimulate job creation. The pricing of future short-term interest rates leaves the door open for disappointment, and a catalyst for the re-pricing of financial assets could be higher than expected US inflation,” he said.
In Europe the economic recovery is uneven. Aggregate demand and credit extension remain poor with deflationary forces having taken hold. The European Central Bank may be tested over coming months to provide some sort of quantitative easing in an effort to weaken the euro. The same is true of Japan where macro-economic progress has stalled.
Growth amongst emerging markets remains desynchronised. China should see marginal improvement with benign inflation allowing monetary policy to be eased further.
Said Mr van der Merwe: “One can expect that easy monetary policy will continue to underpin asset prices. However, ranging from fairly valued to slightly over-valued, equity valuations at this stage of the business cycle will depend on company earnings growth to sustain them. This should mute return expectations for equities as earnings growth will be more dependent on revenue growth in a low economic growth environment.
“A shake-out in stocks could occur when financial markets face the prospect of rising interest rates, but this should not herald a bear market for equities. A potential catalyst could be rising US inflation, but any correction should offer a buying opportunity as we continue to see equities outperforming bonds over the next 12 months.”
He added that Novare Investments was underweight in domestic equities as economic growth forecasts continue to be paired back.
“Economic growth in South Africa is cyclically constrained, reflecting excess capacity created during the previous boom. Business and consumer confidence are depressed and the Reserve Bank’s leading indicator continues to point at a further loss of momentum in the economy. Monetary policy is tightening and will exert pressure on consumer demand.
“To counter weak returns from domestic asset prices, and since cash will probably provide negative real returns, we advocate an overweight position in offshore investments that will improve diversification and take advantage of potential currency weakness.”
Mr van der Merwe said that, given the contribution of manufacturing and mining to GDP, the domestic economy should be prospering amidst a global recovery. But the shackles of industrial action have kept economic activity depressed. In addition, domestic fundamentals weakened and cracks in the economy widened. Stagflation, an environment of weak economic growth amidst rising inflation, has taken hold and credit rating agencies have their sights squarely set on the country.
“Policymakers failed to stay ahead of the curve with regards to fiscal, monetary and financial policy. The general elections and the announcement of a new cabinet provided the perfect platform to announce much needed reforms, but they remained absent,” he added.