|All of the CIO interviews|
The rally in developed-market government bonds and the sell-off in energy markets were by far the biggest surprises. The government bonds rally was driven by increasing disappointment in European growth and rising concern about the disinflationary challenges ahead.
Aggressive monetary policy action in Japan also had an impact, effectively making the US bond market the 'cheapest' developed bond market to own. The increasing interest rate differentials across developed markets are going to add to momentum behind US dollar strength as well as lower-for-longer interest rate expectations.
With regard to the collapse in oil prices, there is a battle for market share going on right now in the energy sector and cartels compete for market share via price. That is going to continue to weigh on inflation expectations, keeping them lower, and add to broader market volatility ahead.
The US will lead developed-market growth in 2015, but the real question is whether it can continue to grow at 2.5% to 3% if global growth stalls out.
We put a 30% probability on Europe slipping into recession in 2015, which means it is not our base case, but it’s a high enough number that we are paying close attention. A weaker euro will help Europe, but quantitative easing (QE) seems more a panacea to animal spirits than an asset reflation tool given how low European bond yields already are.
Emerging markets are the wild card, especially commodity exporters. Latin America, emerging Europe and Africa stand out as concerns. Asia looks well-positioned for another year of slower but solid growth and China will grow by 6.5% to 7% as it continues the structural transformation of its economy.
What is your view on fixed income for 2015?
We expect more of the same, with higher volatility. We are early in a rising rate cycle that remains a one-step forward, two-steps back price-discovery dance for bond markets.
Rates will move higher, but much slower than expected and with a real possibility that if the European economy gets worse, government bond yields will go lower before re-pricing off the Fed’s policy rate 'lift-off” mid-year. That leaves us underweight fixed income and exercising caution.
We own bonds across our portfolios; we just own less as we navigate around where we expect to see the most price pressure – the two- to five-year part of the yield curve. Bond yields are too low and price volatility too high for us to want to be more aggressive with duration.
Which asset classes do you expect to outperform?
Equity markets should outperform this year, but with lower returns and higher volatility. Nothing we own across global equity markets is cheap, and the things that are cheap will remain so because of the fundamentals – so we don’t want to own them. We are currently overweight the US and Asia.
Inflation expectations matter this year, and we will need a little more inflation for multiples to be able to move higher. We aren’t near an equity-market bubble as equity markets continue to feel about fairly valued.
Returns are going to be driven by earnings and dividends, and price discovery is going to be more dynamic. Our biggest overweight across portfolios, like 2014, remains to equity markets – funded from underweight positions in commodities and fixed income.
Biggest unknowns/risks for 2015?
I wish I knew the answer to the biggest unknown. The biggest macro risk this year we see coming is from rising disinflationary pressure, especially in Europe where the 'Japanification' of Europe will become a market discussion point again.
Too far, too fast of anything is rarely good news. The collapse we have seen in European government bond yields and oil prices are each going to lower the inflation outlook ahead. There comes a tipping point at which disinflation becomes something worse and central banks no longer have the ability to revive animal spirits, which is why the Bank of Japan is 'all in' on asset reflation and the European Central Bank is running out of time for simple QE to fundamentally matter.
Geopolitics is scarier this year than it has been in a long time and a further collapse in energy prices might create tail risks from credit downgrades, defaults and debt restructuring, not to mention political turmoil across pockets of emerging Europe, Africa and Latin America.
And in the background, there is still the question of when an exit mechanism is shaped – forced or elected – for Europe’s monetary union and the euro; something that still needs to be defined.