The outlook for equities
Derrik Laver of Laver Financial discusses the outlook for global financial markets.
The outlook for global financial markets is uncertain: much depends upon how the Federal Reserve micro manages the withdrawal of quantitative easing (QE) which has been supportive of both bond and equity prices since it began in 2009.
Reduce it too quickly and the markets will panic; bond yields will rise, forcing up US mortgage rates and possibly stalling the recovery in the housing market, which is fundamental to investor confidence. Reduce it too slowly and the prospect of inflation will become a real danger, leading to higher interest rates and a boom bust scenario.
The fact that the Federal Reserve has signaled that QE may end in 2014 is essentially good news, for it means that the US economy is returning to a position of sustainable growth and no longer needs the support of extreme monetary policy.
Interest rates need to normalize so that banks have the incentive to lend and savers are no longer penalized.
However, markets have become dependent upon a seemingly endless supply of free money poring into the system via the purchase of government bonds and mortgaged-backed securities, inflating both bond and share prices.
Take this stimulus away and the market will suffer withdrawal symptoms. Imagine being on a diet of junk food and coffee and then replacing it with balanced meals, 5-a-day and plenty of water – there is bound to be a period of adjustment.
We have been focusing upon the US because it is still the largest global economy by virtue of its 300 million consumers and, of the developed western economies, is furthest advanced in its recovery phase.
In other parts of the world the QE experiment is far from over: in the UK it is on hold, in Japan it has only recently begun and in Europe it has not yet started.
Thus for the next 12 months there should be sufficient liquidity to prop up equity prices until real growth and higher corporate earnings take its place.
This does place a great deal of responsibility upon America to create sufficient demand to kick-start other economies.
At present they are getting no help from China where output has been contracting, nor from SE Asia where exports have suffered because of the exchange rate advantage handed to Japan as a result of its QE program devaluing the Yen.
Given a gradual pick up in growth, the medium term outlook for equities is promising, however significant risks do remain.