2014 Mid-Year Investment Outlook: Life After Zero

As we enter the second-half of 2014, we evaluate the market and question: "What are the implications of the first post-crisis divergence in central bank strategy?" and "What does life after zero (rates) look like?"

BlackRock's overall outlook remains essentially unchanged. We maintain our baseline scenario of "Low for Longer", but recognise that market leadership can change quickly. We believe:

• Valuations are becoming stretched across markets and investor complacency is high. Many asset owners hold similar investments: long credit, long momentum and short emerging markets (EM) risk. This sets markets up for more volatility – especially as the focus shifts from the end of US quantitative easing (QE) to worries about the timing and magnitude of US interest rate hikes.
• The biggest change over the past six months? A brewing crisis in emerging markets has stabilised. Many economies have adjusted and started closing current account deficits, setting the stage for an economic and market rebound. Selection is key, as countries develop at very different speeds.
• The US Federal Reserve has stuck to the mantra of keeping rates low with great conviction – despite mounting evidence the US economy is set to improve. The risk? When it shifts gears, markets are going to notice. Think steeper (and earlier) rate hikes than the market currently expects – but a lower peak federal funds rate than in previous cycles. Also watch out when QE ceases by year-end: The Fed’s reduced bond buying still gobbles up an outsized portion of net debt issuance.
• The European Central Bank (ECB)’s resolve to prevent the eurozone from falling into a deflationary spiral is likely good news for European risk assets. Watch current account balances to gauge competitiveness and the ECB’s manoeuvring room to start an asset purchase programme.
• We are bullish on Japanese equities – despite recent underperformance. Reasons include Godzilla-like QE by the Bank of Japan (BoJ), cheap valuations, structural reforms to boost economic growth, and a rise in domestic investor interest. Expectations on China’s GDP growth may edge down further. Its investment-fuelled economic model is not sustainable. Structural reform is the only way out – but it may push down growth in the short term. Worries about a credit blowout look overdone.

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