2014 could see sustained acceleration in global growth according to Bill O’Neill.

Notwithstanding the current political infighting in Washington, the economic outlook is for a sustained acceleration in global growth in 2014. This will be led by a US economy driven by stronger private sector demand, a return to very modest growth from the Eurozone and a Chinese economy that we expect to roughly maintain its current growth rate.

Although near-term US GDP growth forecasts are likely to shrink because of the government shutdown, we expect US growth to reach 3 per cent next year after a more difficult 2013. (We currently forecast this year’s growth to be 1.7 per cent). This slowdown was driven by the US finally starting to address its budget position.

Congress raised taxes and cut spending, with the Federal budget improving by 1.7 per cent of GDP. However, in response, households drew down on their savings as confidence in the future grew, offsetting some but not all of the fiscal consolidation. As the private sector drives improvements to underlying economic conditions, unemployment will fall, enabling the Federal Reserve to trigger a light tapering down of bond purchases in coming months.

We expect the European Central Bank to provide a credible backstop for containing the most severe Eurozone break-up risks by continuing to reinforce its message of very easy money. This should be sufficient to maintain the modest improvement in the fortunes for an economy that in aggregate has been in recession for five quarters prior to the latest quarter two data.

German growth should be driven by domestic demand supported by flood-damage related construction. In contrast, French consumers are likely to witness little growth as the government seeks to re-energise the business community at their expense.

A myriad of pending policy related decisions are expected soon, such as on Greece (more funding), Portugal (new funding programme), and Ireland (conditional support programme).

The UK’s approach to fiscal consolidation lies in-between a growth-orientated US and a budget-orientated Eurozone, and its growth profile to date has matched this positioning. The mood in the UK switched dramatically between the first and second quarters this year; with consensus third-quarter growth prospects (relative to the previous quarter) now between 0.7 and 1.0 per cent (UBS expects 0.9 per cent). {{image:{"asset":"23C2816F-4C0D-44D9-AE0E56EE1277B7F2","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}

What happens after that is more complex, but we have raised our UK 2014 growth forecast to 2.3 per cent on the basis of improving household consumption and some investment growth. The latter only shows up so far in construction, the former depends upon real wage growth, which in turn should be driven by productivity improvements. Although the short-term direct effect on GDP of gently rising house prices will be very modest, the change of sentiment this drives is more important.

One indicator we monitor on a regular basis is the Funding for Lending Scheme (FLS) data from the Bank of England. Because this is broken down by institution, it provides a window on which banks are starting to expand credit and those that persist as problems. Both the household consumption and investment growth mentioned above depend on better credit conditions. Cumulative net lending is negative, but at inflection point now.

We expect the current modest increase in Chinese growth to last until year-end, giving a growth forecast of 7.5 per cent. However, by then some overall slowing should be visible. Since Premier Li’s July message to stabilise growth and implement various reform measures, sentiment has improved and economic growth has steadied on better exports, investment and production data. With more signs of improvement in cyclical growth, we expect the government to sustain the ongoing policy of fine-tuning, but not to engage in any high profile stimulus. A necessary slowdown in credit growth will have started to take its toll on growth by the start of next year.

Recent data shows improving growth in emerging markets (EM). We expect 2013 real GDP growth in EM to come in at 4.4 per cent, and accelerate to 5 per cent in 2014. In India, we expect 2013 real GDP growth of 4.7 per cent, while in Brazil and Russia we expect full-year real GDP growth of 2.3 per cent and 1.7 per cent. Next year those growth forecasts are 5.7 per cent, 3.3 per cent and 2.8 per cent respectively.

In summary, the global outlook is for modest expansion, driven by the US, but reliant on improving EM fortunes and a mildly improving Eurozone economy. The main source of upside to this forecast would be a stronger than expected Eurozone economy. In contrast the three primary risks at the time of writing are a significant escalation of the Eurozone debt crisis; a protracted government shutdown and a sharper fiscal contraction in the US; and further weakness in Chinese growth as a result of either domestic policy tightening or weaker exports. Both these more positive and more negative scenarios have about a 20 per cent probability, in our view.

Asset allocation

Given synchronised G7 recovery and ultra-loose monetary policy, it is no surprise that we remain constructive generally on risk assets, especially those sensitive to the US where private sector deleveraging is at an advanced stage and corporates are at last looking at committing to investment. That said, the paramount driver of the last five years – abundant, cheap liquidity – is losing its potency. Quantitative easing (QE) will be gradually but not prematurely dismantled, beginning in the US. The recent correction reflected that realisation.

We do see markets on the cusp of a second, more prolonged phase driven by growth in corporate profits. Historically, equity markets have outperformed in this environment, especially against high-grade bonds. The downside risk is a badly managed exit from QE that causes credit conditions to tighten and in so doing puts the recovery at risk. UBS WM favours US equities, as the economy rests on a stronger footing than other regions. Earnings growth is expected at 7 per cent in 2013 and 8 per cent in 2014, buoyed by solid domestic demand. {{image:{"asset":"DBB86788-2286-4725-A1DDCA9DDA224E29","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}

Japanese equities are still benefiting from the big fall in the yen since last year. The Bank of Japan is pursuing its very aggressive easing policy and inflation has turned positive. We are overweighting Japanese equities but anticipate sustained volatility.

We have a neutral stance on Eurozone and emerging market equities. The Eurozone economy exited recession in the second quarter of 2013. Leading indicators have improved further over the summer. Nevertheless, Eurozone company earnings have continued to decline (see chart 2) in sharp contrast to those of the US and Japan. In the UK, as in the US, our preference is still toward the midcap sector which will best capture exposure to upgrades to domestic GDP growth. Economic growth shows a tentative improvement in Asia but not yet broad-based across EM. Downside risks to growth remain, especially in countries with current account deficits.

The call on bond markets is still to avoid interest (duration) risk as the cycle normalises. We still expect bond yields to stabilise once QE tapering has commenced at the end of this year. A first rate hike is still further out and therefore upward pressure for yields should be contained, especially after the US dollar ten-year benchmark yield has adjusted higher during recent months. We prefer investment-grade and US high-yield corporate bonds over high-grade bonds against a sustained improvement in the economic environment. Hard currency EM sovereign and corporate bond valuations are attractive. However, the weaker EM economic environment and lower commodity prices are headwinds to EM bonds, pointing to further bouts of higher price volatility.

Commodity prices have been struggling to keep up with improving macroeconomic data. The supply situation for crude oil may well improve towards the end of this year with supply outages topping out. Given geopolitical concerns in the Middle East, an improved supply side is not strong enough to bring prices immediately lower. This should change in 2014 with non- OPEC supply advancing and Brent crude oil prices testing $100/bbl.

We expect the Euro/US dollar to stay range-bound within 1.30 and 1.38 US dollars. The dollar has weakened due to the Fed’s decision to leave QE unchanged.

However, the US economy is improving and it is likely that QE tapering will start relatively soon. Sterling has potential due to the rebound of the UK economy. Nonetheless, the forward guidance of the Bank of England sets a limit to the strength of the pound.

Bill O’Neill, managing director and head of CIO, WM Research UK, UBS AG.