Context is all

Context is all

Posted on 24 January 2014

Consistency is the last refuge of the unimaginative – Wilde
Nobody said capital markets have to be consistent, but sometimes they seem more inconsistent than they really are. Here’s country A, with likely 2014 growth at 2-3%, government and balance of payments deficits at 5% and 4% of GDP respectively, surging house prices, and interest rates that seem likely to rise. Its stock market and currency have been going up. Then there’s country B: 2014 growth is also put at 2-3%, government and external deficits are 3% and 4%, house prices are high and interest rates have just risen. Its stocks and currency have been falling. On paper, performance looks similar, yet investors clearly see the two countries very differently.

In practice, context and expectations matter hugely. Country A is the UK: 2-3% growth represents an acceleration from recent trends, and one that has caught most economists on the hop. The government deficit will have halved, recent current account news largely reflects reviving domestic demand, and the surge in national house prices follows stagnation. Unemployment is likely to fall below the “forward guidance” threshold of 7% soon, more than two years earlier than the Bank of England initially expected. The bank says its guidance is not rigid (see below), inflation is under control and interest rates won’t rise soon, but its hand could be forced by the growing economy (as we’ve long argued).

Country B is Brazil, where 2-3% growth and a payments deficit is a big disappointment after the high hopes of export-led ‘BRIC’ success. Elevated real estate prices and stubborn inflation look more like a hangover than an aperitif. The central bank was bounced into raising official interest rates – to 10.5% – not by vigorous growth but by the need to deal with that hangover, made more painful in the short-term by the weak real.

A similar divergence is visible across developed and emerging blocs, and if anything has become more so in the last few weeks. Low expectations of growth in the West are being beaten, and deficit blemishes are being tolerated by investors who had overlooked the possibility of a cyclical revival. The economic news from emerging markets (EM) is not bad exactly, but disappointing, and developments in Argentina, Egypt, South Africa, Thailand and Turkey amongst others have offered a rude reminder that EM assets carry the highest risk. As the Federal Reserve begins to reduce the liquidity it is injecting, investors seem less willing to provide capital to countries that weren’t supposed to need it this time around.

Emerging stocks have underperformed for several years, and look relatively inexpensive. Our EM wariness is most pronounced in the case of bonds (where we are tactically underweight) and currencies, and developed rather than emerging markets still look most attractive. We’ve noted that history tells us that even at this late stage, EM stocks are capable of underperforming not just developed markets but other asset classes for a while longer. As yet, however, we haven’t been expecting a re-run of 1996-8 – not least because the Asian bloc, the source of volatility then and the biggest EM region by far, does look better behaved now, recent disappointments notwithstanding.

Kevin Gardiner, Chief Investment Officer, Europe

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