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Equity markets could face a difficult year in 2015
FOR several years equity markets have been able to weather various geopolitical concerns, ranging from worries that Greece's financial woes would lead to a collapse of the eurozone to more recent problems in Ukraine, the Middle East and the Ebola outbreak in Africa.
Much of the credit for this resilience has to go to developed markets' central banks for their quantitative easing (QE) programmes that provided valuable liquidity support during periods of turbulence. This started with the US Federal Reserve and was adopted by the European Central Bank and the Bank of Japan over the past four to five years and has ensured that financial markets have remained on a relatively even keel.
In the months ahead, this is set to change - the largest QE provider, the Fed, has ended its programme two weeks ago as it believes the economic expansion in the US is on track. Although Japan and Europe appear determined to try and reflate their economies with more rounds of QE, markets are now adjusting to assets being allocated on the basis of liquidity flows to a more familiar allocation based on growth. On this count, however, the signs for 2015 are not overly encouraging for equity markets.
On Monday, for example, regional stocks were rocked by news that Japan's economy has sunk into a technical recession - for the three months ended Sept 30, gross domestic product shrank 1.6 per cent quarter-on-quarter compared to expectations of a 2.2 per cent expansion.
The Nikkei 225 plunged just under 3 per cent in response but, more importantly, the shock contraction led many to question the health of the world economy. The global recovery has been described as slow and uneven by leaders at the G-20 summit in Brisbane, at which British Prime Minister David Cameron warned that "red warning lights are flashing on the dashboard of the global economy" in the same way as when the US subprime crisis brought the world to its knees six years ago.
His warning comes days after Bank of England governor Mark Carney claimed a spectre of stagnation was haunting Europe. The International Monetary Fund's managing director Christine Lagarde expressed fears at the summit that a diet of high debt, low growth and unemployment may yet become "the new normal in Europe".
Over in the US, there is talk that even if the expansion is on track, inflation at a 60-year low at a time when monetary policy has been unusually loose raises the uncomfortable possibility that the next problem to be dealt with is deflation, a condition which is already afflicting parts of the eurozone. Investors in Japan would be familiar with deflation, with which the country has grappled, unsuccessfully, for more than 20 years.
As far as markets are concerned, the most important consideration for the moment is when the Fed will raise interest rates. Credit Suisse in its 2015 Global Outlook released this week said that it expects this to occur in the middle of next year, and because of this, it is optimistic on equities for the first half but fears a significant correction in the second six months.
The best that can be said for now is that as markets transition from liquidity to a growth-based allocation, volatility will increase. It is also likely that geopolitical risk, which has not played a significant role for several years, could well become important. A difficult 2015 lies ahead for stock markets.