Schroders: Lack of recovery in the emerging world

After a strong first quarter, equity markets took a breather in the second as the action switched to bond markets. Having fallen to almost zero, German 10-year bond yields rose sharply as evidence of better growth and an end to deflation led many to question the European Central Bank’s (ECB) commitment to quantitative easing. Mario Draghi has subsequently reassured investors that the programme remains in place and volatility has subsequently subsided. One factor which will keep the programme in place is the turmoil in Greece where ECB action would be critical in quelling financial market contagion across the region should Greece leave the euro (“Grexit”).

Looking ahead, we see a pick-up in global activity as the US bounces back from a weak first quarter and growth in Europe and Japan resumes. An exit from the euro by Greece, whilst clearly shocking, would put a dent in this, but would not derail the world economy in our view. At 2% of eurozone GDP, Greece is simply not large enough as an economy whilst there are firewalls in place to prevent significant financial contagion to the rest of Europe and beyond.

The other key feature of the global picture is a lack of recovery in the emerging world with China continuing to struggle, prompting the announcement of further stimulus by the authorities. Efforts to drive up the equity market and recapitalise large parts of China’s corporate sector have been unravelling as the market has slumped in recent weeks.

Our asset allocation remains positive on equities with a focus on Europe where we see better prospects for earnings growth compared to the US, which is showing signs of margin pressure as wage costs rise. After the general election, the reduction in political risk should boost the UK. It is too early to go back into the emerging markets particularly with the Federal Reserve likely to tighten policy later in the year and the US dollar expected to remain firm.

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