As we move toward the end of 2014, the themes that we expect to drive markets in the coming year are really starting to take shape. Foremost among them is the divergence of monetary policy. To that end, the past week has seen two major events that we believe will set the scene for 2015. So far, the divergence theme has been dominated by the easing camp, with action in Asia and talk in Europe. The latest instalment of the European quantitative easing (QE) debate came in the form of the December meeting of the governing council of the European Central Bank (ECB). Expectations for more easing in Europe has risen sharply over the past month, and the collapse in oil prices has, once again, raised the fear of deflation in the Eurozone. In fact, yet more disappointing data has driven the inflation swaps market to price headline inflation dropping below zero for the first time ever in the first quarter of 2015. The hope for more action has been exacerbated, both by the rise in rhetoric from ECB members and by the actions of other central banks. In this regard, the recent easing by both the Bank of Japan (BoJ) and the People’s Bank of China (PBOC) have piled increasing pressure on the ECB to do more.
In line with our expectations, ECB President Mario Draghi stopped short of announcing any new policy tools. However, it was clear from the tone of the Q&A that sovereign QE in Europe remains very much in the cards. With a nod to one of the conditions he laid out last month – i.e. that if existing measures prove too little, they may have to do more – Mr Draghi said that the current policies will be reviewed in early 2015. This, for the first time, helped set a timetable to review the policies, and, if deemed necessary, to move to the next stage of monetary easing. The first sign for that condition will be the announcement of the take-up of the second-tier of targeted long-term refinancing operations (TLTRO) on 11 December. Also notable was the clear message that legal hurdles are surmountable. In fact, according to Mr Draghi, the only illegality is allowing the ECB to move away from its inflation and growth mandate – a clear shot across the bowels of the QE doubters. Market reaction to the announcement (or lack of an announcement) was to price out some of the more exuberant price action of recent weeks, in both peripheral bonds and European equities, on Thursday afternoon. However, the disappointment didn’t last long, with markets bouncing back sharply on Friday – helped by some positive press on the chances for QE in 2015 – most notably in Germany.
On the other side of the Atlantic, the divergence theme has been particularly quiet. In fact, US Treasury yields have been held low, driven by the widening gap in yield with core Europe and the expanding search for income around the world. Behind the scenes, though, the drivers of the tightening camp are starting to pick up. This was confirmed by the latest non-farm payrolls data, which showed the strongest positive surprise since January 2012, coming in at 321,000 versus a survey estimate of 230,000. With October revised upward as well, and hourly earnings beating expectations, it was a strong report all around. Coming on top of the increase in the recent employment cost index – the Federal Reserve (Fed)’s favoured measure of income – the pressure for rising wages is clearly growing. And this is key: the missing link of wages and incomes in the US looks to be appearing fast. As we move into 2015, it is difficult to see the Fed not moving to a more hawkish stance as it prepares for what we believe will be a first hike in the Fed’s funds rate by the middle of next year. That step could come as early as this month, when the Fed may adjust the language regarding timing in a Federal Open Markets Committee meeting.
The strong growth data was taken positively by equity markets, with the S&P 500 creeping up to end on yet another weekly high – its seventh in a row – and the Dow Jones fast approaching 18,000. So far, the good news of an improving labour market is outweighing the bad news of what it might mean for the Fed’s easing stance once they start the hike. This is no small measure, due to the baton change of central-bank QE from the Fed to the BoJ, and possibly the ECB, next year. Even bond markets were relatively sanguine: the 7 basis-point (bps) rise in 10-year yields on Friday took them to 2.31%, still below where they were before September’s Fed meeting.
The winners continued to be Japan & China
While the main news came from Europe and the US, for markets, the winners continued to be Japan and China. Both sustained their positive recent momentum, with A shares up another 9% and the Nikkei up over 2.5% to close at a seven-year high. Rising volumes in A-share markets are encouraging hopes that domestic investors may finally be buying back into their own equity market. The strength of the US dollar also continues to provide strong support to Japan, with the dollar-yen exchange hitting 121.5 on Friday. For emerging markets, the dollar strength remains a significant headwind: broad emerging-market indices were down just shy of 2%. The combination of ongoing European QE hopes and the spectre of the Fed has pushed the euro-dollar exchange below 123, which will continue to help both exporters and Germany. After months of disappointment, tentative signs of a cyclical improvement in the Eurozone economy are appearing, with factory orders in Germany rising strongly. Note that autos helped drive the pick-up in these orders; this is a sector we think should benefit as we move into next year.