Investment themes

J.P. Morgan's Kerry Craig (Global market Strategist) gives us his views on the performance of markets so far this year and the themes investors will need to grapple with in the next three months:

Economic instability made for a shaky first quarter. The potential for deflation in Europe, questions about the ability of Japanese prime minister Shinzo Abe to reignite his nation’s economy, and the weather-plagued US economy all contributed to mixed returns.

Meanwhile, in emerging markets, there was a general concern about the slowdown in credit growth in China and the potential for a sharp rise in defaults in wealth products (which we don’t think will materialise). There was increasing social unrest in Brazil, Venezuela and Thailand, as well as rising geopolitical tension in Turkey and Ukraine. While Ukraine has dominated headlines, the direct impact for investors is marginal given the size of Ukraine’s economy and stock market. Even the Russian Micex index regained some of its lost ground recently.

All of this has meant that investors are pausing to take stock as we enter the second quarter of the year. Some are feeling let down, as it has not been the start to the year that many expected. Fixed income and gold are outperforming equities, in stark contrast to the stellar performance of developed market equities in 2013.

Short-term bouts of economic or political pain are challenging, but there are reasons to still favour risk assets. Globally, the inflation outlook is relatively benign, while economic momentum is improving in the developed world and monetary policy remains very accommodative.

European economic data confirms the ongoing recovery and manufacturing numbers show that the region’s largest economies – France, Germany, Italy and Spain – are all in expansionary territory. Consumer confidence surged in February, suggesting the spectre of deflation has yet to scare consumers into a Japanese-style deflationary spiral. At present, growth in the single currency region looks more likely to surprise on the upside than the down, despite the risks of low inflation.

In the US, a spring thaw may be on the way. The cold weather merely postponed demand in the economy and, after a slow first quarter, growth is set to pick up again. Job growth has been muted, but wages are rising and average earnings for production workers were up 2.5% year-on-year at the end of February, the fastest in three years. Higher wages and growing employment will support consumer demand. Moreover, companies will soon begin to spend some of the mountains of cash they have hoarded in recent years and this should support earnings and equity markets.

The Federal Reserve (Fed), the Bank of England and the European Central Bank have all taken steps to force down both short- and long-term interest rates, which has made traditional bond investments look relatively unattractive compared with equities. Even as the Fed tapers its bond purchase programme and expectations of the first rate hikes by the Bank of England and the Fed are brought forward, there is little chance of higher rates this year, and investors should lean towards equities – especially as economies get back on track after a tough winter. However, the better performance of safe haven assets in the first quarter highlights that there are still risks to the global economic recovery.

Still, developed equity markets are likely to outperform fixed income, even after the shaky start to the year.

In our view, the four themes that investors will grapple with in the next three months are:

• 2014 has been kinder to core fixed income assets than previously expected, but the eventual rise in interest rates will still create challenges for the asset class. It underlines the need for more diversified fixed income investing.
• The European recovery is not yet reflected in corporate earnings. Will this year see a turn in the earnings cycle?
• Emerging markets remain an unloved asset class, but current valuations are difficult to ignore.
• Political risks and upcoming elections create uncertainty and add to market volatility, but does that cloud the fundamentals?