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Much has been said about the remarkable run credit market have had so far in 2014. Question marks remain however, as to how sustainable this rally is. There are a handful of risks that could bring an abrupt halt to this rally, but they have only proven to be tail risk in nature so far. Firstly, the euro zone economy could slide into yet another recession, or on the flipside of things, economic growth can begin to accelerate thanks to better fundamentals in the US and/or China, ultimately resulting in a rise in benchmark yields, putting pressure on spreads. However, there is no apparent indicator which point to such scenario in the Euro zone, for the time being, and we are likely to tread on the current path of lacklustre growth, high unemployment and low inflation, with the low yields and rates environment lasting for longer.
Having said that, the possibility of a market shock, such as a sovereign or debt crisis, however with the current stance central banks have taken, it would be hard to believe that they will let things go down that route again. This leads us to believe that, given current market circumstances, the only risk investors need worry about, in the short term, is merely credit spreads; the ultra-low yield environment is expected to continue, and it is very likely credit yields will keep falling in the coming months, rendering the stock selection process more crucial than ever.
All in all, market consensus is for a slight gain in global economic tractions in the months ahead; US growth should trend above 3% till end 2014, whilst the euro zone will make up some ground on the back of a strong economic recovery in the periphery, while China growth looks to have bottomed-out in Q1, moving forward with an export-led recovery. Despite the improving growth outlook, central banks continue to maintain their dovish bias given the fragile nature of the recovery to date, the ongoing need for deleveraging and the threat of persistently low inflation. Despite the apparent differing stages of the accommodative cycle between the Euro zone and the US (the ECB has recently increased its accommodative monetary policy stance following the June meeting, whilst the Fed is slowly exiting is accommodative measures), the combination of recovering growth and ultra-accommodative monetary policy has proved to be te so-called winning formula for markets; major equity indices are near all-time highs, credit spreads have continued to tighten, peripheral yields are at historic lows, all this in a scenario in which volatility and correlation are back at pre-crisis (September 2008) levels.
Although we are of the opinion that this market equilibrium can last a bit long, we remain aware that the trend can be bucked, as early as September if the Fed breaks from its ultra-dovish tone amid rising inflation and improving data in the US. While a sharp reversal in US monetary policy is largely unlikely to lead to a repeat of what happened 14 months ahead (following the Fed’s initial announcement of the tapering program), volatility could well begin its uptick if central bank policies surprise (US Federal Reserve and Bank of England move towards tightening fiscal conditions, whilst the ECB and Bank of Japan reiterate their easing stance). Going forward, incoming economic data will be the main focus for markets and will drive market sentiment, expectations and valuations.
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