We are relatively constructive on global economic growth. The US economy is expected to accelerate in 2015 as the weakness seen in Q1 2014 is unlikely to be repeated. Europe and Japan are also likely to post slightly stronger growth next year. The main fly in the ointment is China, which we expect to decelerate somewhat as the authorities remain focused on reforms that naturally represent a trade off between short term and long term growth.

 

Meanwhile, inflation is expected to remain relatively benign with the global output gap remaining wide and lower oil prices reducing inflationary pressures. This should allow the majority of central banks to loosen monetary policy, supporting risk appetite.

 

However, we believe 2015 is likely to see traditional asset classes generate lower, but still positive, investment returns. Global equity valuations have generally increased over the past 2-3 years. We do not think this is something to be too concerned about, but it does mean that forward-looking returns are unlikely to be as strong as they have been (they have risen almost 50% since the end of 2011 on a total-return basis). Meanwhile, bond yields have discounted a lot of disinflationary pressures already, which means any upside surprise on the growth/inflation front could undermine returns here as well.

 

We are also likely to see volatility increase in 2015. The first US Federal Reserve Board (Fed) rate hike of the cycle is normally a period associated with increased market volatility. The good news is the Fed looks keen to err on the side of caution. Therefore, any rise in interest rates is likely to gradual and well-signalled. The bad news is the market is pricing in a slower pace of rate hikes than the Fed’s committee members are forecasting. The gap will have to narrow in 2015, either with Fed members reducing the pace of forecast rate rises or the market adjusting their expectations up somewhat. We expect a combination of the two, but this still implies a market adjustment which could increase short term volatility.

 

Just to be clear, we do not believe that we are near the end of the developed market equity bull market. History teaches us that equity markets usually rise well into the rate hiking cycle – usually until the Fed’s focus shifts to combating inflation rather than supporting growth. However, lower returns and higher volatility will make gains feel much harder to achieve than they have been since 2012.

 

It is against this backdrop that we believe investors need to W.I.D.E.N. their investment horizons to areas less travelled. This includes taking advantage of higher volatility by selling options as volatility spikes – a more conventional approach would be to buy developed market equities on dips, a strategy we expect to remain profitable in 2015. It also includes selective investments in some Asian local currency bond markets such as China and India, an area that clearly fits into our theme of adopting a diversified approach to income investing. Finally, there are many alternative strategies that we believe will generate a good risk-return profile in 2015, relative to the more traditional asset classes.

 

Overall, we remain constructive on risk assets, despite the likelihood of the Fed hiking interest rates for the first time since 2006. However, we would recommend investors consider complementing global equity investments with less traditional sources of returns.