Turning to the second half

Fund performance was disappointing over the month and quarter as the rally in bonds led markets to focus on yield and value rather than growth.

Investment managers have been concerned with global deflation risks in recent months. Bonds rallied and bond sensitive equities have performed very strongly. This implies the economic cycle is dead or that risk is non-existent – both dangerous assumptions to make. Looking into the second half of 2014 we expect this trend to wane with investors increasing exposure to more cyclical sectors as global growth and inflation expectations continue to firm.

Growth equities have under-performed, locally and globally over the last quarter. This has been somewhat surprising with growth indicators improving and if anything inflation data has picked up in many countries. For instance in the US, UK and China inflation measures are creeping up. Policy makers seem okay with this. Astonishingly the IMF has just published a paper saying that inflation at 4% should be seen as a long run target, which would clearly make our Reserve Bank very uncomfortable. However, markets don’t seem to believe this will happen with inflation index bonds showing no real inflation shock priced-in. This is worth watching carefully as the range of higher surprises on inflation data rises. For instance the CRB commodity index is up significantly (led by oil, food and more recently metals), the US Philly Fed prices paid index had a marked jump, the US headline rate was higher than expected, and hourly earnings are also accelerating.

Closer to home, in NZ, housing sector inflation continues to lead the indicators, but a stronger exchange rate is quelling other pressures for now. As illustrated in Figure 1 global equities tend to outperform treasury bonds during periods where US inflation is increasing.