2014 in three words: deflation and lower returns

While the year 2014 began with expectations of higher growth, higher yields and higher stocks, it is ending with the reality of lower inflation, lower yields and higher stocks, a report said.

It also ends with asset markets and the bull case for risk assets still embarrassingly dependent on central bank intervention, added the recent report from Bank of America (BofA) Merrill Lynch Global Research titled "Thundering Word: The Year Behind”.

Global central bank assets, including foreign exchange reserves, now stand at $22.6 trillion, a sum larger than the combined GDP of the US and Japan, the report said.

Aggressive central bank in 2014 led to higher spreads and volatility, disappointing fixed returns and lower, more volatile and narrower equity returns. “Expect more of the same next year unless non-US EPS surprises on upside via reform,” the research report warned.

Eighty-three per cent of world equity market cap is currently supported by zero interest rate policies; and 50 per cent of all government bonds in the world currently yield 1 per cent or less, it noted.

And yet the total return from global government bond markets in 2013 and 2014 combined is on course to fall 4 per cent, the worst two-year return since the early-80s.

Flight to growth, quality and more liquid assets

Nervousness over the withdrawal of that intervention in the US and UK, or failure of that intervention in Europe and Japan has caused an unambiguous flight to “growth”, “quality” and “liquidity” in 2014.

The QE leadership of high yield and small cap stocks faltered badly this year. And investors rotated to stocks in search of yield allowing the modest but dogged outperformance of high dividend- yielding stocks versus high yield corporate bonds to continue.

The best performing asset of 2014, the dollar, benefitted from “flight to quality”. Long dollar is the consensus trade going into 2015 and this will at some point be challenged, the report said.

The dollar is at an early stage of a secular bull market and should work so long as the Fed can raise rates next year for the first time since 2006.

Reform with Reflation is a winning strategy

In EM the spoils clearly went to markets where politicians/electorates embraced reform. It worked big time in India.

Indonesia did well too, according to BofA Merrill Lynch Global Research report. Those that did not embrace reform (Argentina, Greece, Russia) were scarred by capital flight.

The year 2014 ends with optimism that reflation and reform could be underway in China and Japan, although Japan needs to prove to investors that their equity market can go up at some point without the lazy help of currency depreciation.

But markets remain extremely doubtful that European Central Bank (ECB) reflation will go hand-in-hand with reform in Europe. Until it does, Europe will remain a positive for volatility and a potential bear catalyst for both equity and credit markets next year.