This is not an ideal investment environment but one we believe should support further gains in the equity markets.
Huge emphasis on US
There are, as always, a number of specific investment risks to consider and many of them are centred on the US due to the huge role its monetary authorities have played in supporting the global economy through asset purchases. The level of dysfunction coming out of Washington presents a significant risk to both the world economy and financial markets.
The ongoing weakness in the US labour market, including subdued wage growth, also leads us to be cautious about how strong the domestic economy could be. And that is important as, after all, US equities account for almost half of the global equity market.
The effect of this year’s tax increases and spending cuts is fading, likely boosting GDP growth in 2014 to around 2.5%.
Compared with other global economies, the picture does not look at all bad and can potentially serve as a springboard for growth.
One much talked-about risk is the prospect of the Federal Reserve’s eventual exit from quantitative easing. Incoming Fed chief Janet Yellen faces a tough challenge in trying to find a way to end an era of ever-easy monetary policies gracefully.
Unemployment mark not a trigger
While that is the eventual goal, Yellen may not start there. She might, for example, give even greater weight to the second part of the Fed’s dual mandate, full employment rather than inflation. This means the exit from QE will likely be offset by reassurances that any interest rate rises are still far away.
In our view, the US unemployment rate could reach the Fed’s threshold of 6.5% by early 2015, yet we expect the monetary authorities to wait longer before raising rates. Instead, we see the Fed using forward guidance, which basically means a lot of soothing promises not to raise rates until the economy is strong enough to warrant it. The Fed might even try to convince investors a little burst of inflation lies around the corner, encouraging people to spend.
A big risk of the Fed’s QE exit is the impact on the key but fickle housing market. The hike in mortgage rates caused by taper fears slowed down home sales and price gains, even though housing affordability remains near its highest level in decades.
US equity valuations could also be impacted by the Fed’s changing policy and they already look fairly fully valued.
So where to from here?
Corporate profits are at a record share of output, with the wage share at a low. This speaks to troubling trends of growing inequality and weak wage growth, bringing into question the sustainability of these margins. If they were to fall to historical averages, earnings would take a hit and equities could head south.
We believe equities can rise further this year from current levels. Also, we feel equities still currently represent better value than cash and bonds. However, further gains will need to come alongside earnings of companies growing. Given the current environment, comprising slow economic growth, sluggish wage growth and lacklustre consumer spending, that may not be easy for companies to achieve.
