Investment clock says time to be bullish

January 9, 2014

The era of money printing is over and the days of zero interest rates are numbered. That's the message from the Bank of England. Measures to stimulate an old-style housing boom are taking effect. Meanwhile, elsewhere in the world a US-led recovery is also under way.

Economic growth is good news for the government in its attempt to shrink the budget deficit, and it should be good news for job seekers, wage earners and hard-pressed owners of small businesses. A normalisation of global monetary policy isn't necessarily good news for investors, however.

Stock and bond markets did exceptionally well out of quantitative easing (QE), but the 'Great Exit' will necessitate a more selective approach to asset allocation. We think developed economy stock markets will weather the removal of central bank liquidity well, but we are cautious on the outlook for government bonds, property shares, commodities and the emerging markets, where interest rate rises and a strong US dollar could spell trouble.

After five years in the economic doldrums, convincing signs of life are returning to the world economy. Output is well above its pre-crisis level, the economy has been improving steadily, unemployment has been falling and house prices have started to rise.

More normal times require more normal policy settings. The US Federal Reserve is likely to scale back and stop QE over 2014, and interest rates will eventually have to rise. Higher US rates will attract international money flows and we expect the dollar to be strong. If you think it's only cheap money that has pushed stock markets higher, you will be worried now.

But we're not. Corporate earnings have grown strongly in recent years, and we expect this to continue. Stock market valuations are not particularly stretched. Our favourite markets are the US, where recovery is most certain, and Japan, where policy is loosest and a weak yen will boost exports.

We think a return to business as usual poses more of a threat to government bonds. A rise in yields could mean further capital losses. Interest rate-sensitive property shares will also come under pressure, though residential property is likely to remain strong.

A search for yield has seen US investors pile into emerging market stocks and bonds over the past few years; as this money heads back home, emerging market currencies will weaken, interest rates will rise and over-investment will be laid bare. Weakness in emerging economies, coupled with excess production capacity built up in the good years, is bad news for commodities.

There may be a silver lining here. We are in the equity-friendly Recovery phase of the Investment Clock cycle. Global growth is strong, while inflation pressures are absent. A broad-based rise in inflation would push us into Overheat, triggering a rapid rise in central bank rates and weakness in a wide range of asset classes. However, spare capacity is still in evidence in the major economies and there's no sign of inflation yet.

If the structural slowdown in China and trouble in the emerging markets triggers sustained commodity price weakness, inflation could actually drop, a rise in real incomes could ease the cost of living crisis - and this economic upswing could last for years.

Trevor Greetham is director of asset allocation at Fidelity Worldwide Investment.

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