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2014 Kicked Off With Too Few Bears

2014 Kicked Off With Too Few Bears

Courtesy of Paul Bains, Pacifica Partners

In 2013, the financial markets began to put the fears rooted in the Financial Crisis behind them as investors began to sense that there was light at the end of the tunnel. Optimism seemed to replace fear and investors began a flight out of the safety of bonds and into equities. As last year drew to a close, eyes and ears began to focus on what 2014 would bring for the markets. Without question, the biggest topic of debate is about the direction of interest rates this year and their impact on the financial markets. From our perspective, the interest rate debate can be broken down to a 'glass half full or half empty' argument. The optimistic perspective is rooted in the belief that interest rates are only returning to a more normal level due to the fact that the global economy is getting stronger. The gloomy argument is that the economic recovery is not strong enough to withstand higher interest rates and it could be cut short just as things were getting back to normal.

Interest Rates: A new normal?

Conventional wisdom coming out of the financial crisis was that the dominance of the US economy would gradually wane as the US was akin to a wounded giant with far too many problems. In addition, it was thought that super charged economic growth rates of China, India and Brazil would shift the fulcrum of the global economic balance away from the US. Over 5 years later, it would be safe to say that the decline in US economic relevance was greatly exaggerated. The US economy is showing the strongest growth rate amongst the G7 group of countries and as the largest economy in the world, the US is a key part of reigniting global economic growth. As economic conditions have stabilized, the US Federal Reserve has begun to take the first tentative steps towards normalizing US interest rates by decreasing its monthly bond purchases from $85 billion to $65 billion. Since these bond purchases (known as quantitative easing) were aimed at keeping interest rates low, the markets have interpreted this as the first step towards a tightening of monetary policy. The bond market has wasted little time in pushing interest rates upwards. In fact, between May and December of last year, interest rates rose at the fastest pace in nearly 50 years. This has many observers wondering if the three decade trend of falling interest rates has come to an end and whether there will be a long term trend shift towards rising interest rates.

Emerging Markets Fall

Historically, the emerging markets have felt firsthand the effect of a backup in US bond yields. It used to be said that whenever the US bond market sneezes, the emerging markets get the flu. Amazingly, despite the enormous wealth created in those nations over the last decade, it seems that they are still at the mercy of the US bond market and interest rates. We are amazed because no matter how much things change, they still remain the same for the emerging markets.

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