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Stephanie Flanders: The 2014 question- how much do you trust the Fed?

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Stock investors ended 2013 on a high note, savouring double-digit returns from developed country equities. But that is not really new. The major developed country stock markets have delivered double digit annual returns in four of the past five years.

What is different, this time, is that for once the enthusiasm in the markets comes with some enthusiasm about the state of the real economy. That is welcome news indeed, after five years of recurrent gloom. But even in the financial markets, optimism can only take you so far.

I’m expecting risk assets to do well again this year, but as we move through 2014, we do need to see hard evidence that market confidence in the recovery is justified. Investors should also be expecting more variation in returns, and more bumps in the road. In that sense it’s ’showtime” – not just for the global recovery but also for asset managers.

What should you be looking out for? Everyone will have their own list. But to my mind, the single most important question that investors should be asking themselves in assessing the global market environment in 2014 is: how much do I trust the Fed?

We are hopefully now getting closer to the day when central banks will not set the tune for financial markets – and most of the notes, to boot. But we are not there yet. Indeed, as we saw last year, it’s in that transition to more normal monetary policies that central banks have most room to mess things up.

The outgoing US Federal Reserve chairman Ben Bernanke caused a fair bit of mayhem in the bond markets, last summer, when he started to talk about a gradual end to quantitative easing. But the Fed’s strategy for communicating and executing this crucial transition looks a lot better now than it did then.

Long rates are higher, but short term interest rates appear well anchored by the Fed’s forward guidance’ on policy rates – and US investors have a clear timetable in mind for the gradual end of QE. So far, so good.

But what matters here is not just the execution of policy – but the underlying substance. Most important, for things to go smoothly, the Fed, and the Bank of England, need to be right in their judgment that the economy still has ample room to grow without triggering inflation.

Financial markets have swallowed this first stage of the normalisation process, but this is built on a widespread expectation (a) that the first rise in policy rates is a long way off and (b) it will only come in the context of a decent economic recovery.

A positive growth “surprise’ in the first half of 2014 is quite possible, particularly in the US, where many forecasters have been raising their forecasts for 2013 and 2014. We had a disappointing US jobs report for December, but otherwise most of the signals from the real economy have been flashing green.

If the US does seem to be stepping into a higher gear as we move into the spring, that would raise question marks about the timing of rate rises – and potentially trigger more volatility in fixed income markets. However, good news on growth would not necessarily be problematic for equities. In fact, history suggests the opposite, at the current low level of policy rates and inflation. 

The big worry is not that the demand side of the recovery will prove stronger than the Federal Reserve and others expect, but that the supply side turns out to be a lot weaker, thereby raising doubts about the quality of the recovery itself.

The disappointing pace of growth is obviously the major reason why monetary policy has remained so loose for so long. But there have been enough ‘extenuating circumstances’ – including the Eurozone debt crisis – to persuade the Fed and the Bank of England that the problem is largely temporary.

Now those external problems have receded, the excuses are running out.  The strength and composition of the recovery in 2014 should provide the best clues yet to whether  ground that has been lost since 2008 can really be regained.

So, it really is show-time for the global recovery in 2014 – and for the major central banks as well.

With that in mind, these would be my key rules of the road for those investing money 2014:

First, Think about rebalancing: If you benefited from the stellar equity returns in 2013 then prudence says you should probably re-balance your portfolio, even if you share the view of our Market Insights team that the bull market has more time to run.

Second, Be selective: With US valuations no longer cheap, there may be more value opportunities in the Eurozone, particularly if earnings start to recover.  Some emerging markets assets also now look attractive, particularly those that should benefit disproportionately from recovery in the US and Europe. But discrimination will be vital – and a long-term view.

And finally, Expect more bumps: The last two years have brought above-average returns to equity investors, with well below-average volatility. Last year was truly exceptional, on both fronts. No-one should be expecting to have such an easy ride in 2014.

Stephanie Flanders is chief market strategist for UK and Europe at JP Morgan Asset Management

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