Reviewing the various forecasts that one has seen so far this year there would appear to be a generally held view that 2014 will be another positive year for risk assets, albeit not as rewarding as 2013. It is however difficult to argue with this bullish view at present.
Global economic momentum is improving led by the US, UK and Japan. The synchronised nature of the central bank support that is being given to the markets is immense and will continue for the foreseeable future. The ease at which the US markets dealt with the implementation of tapering before Christmas was impressive. It should be remembered that despite this gradual monthly reduction of bond purchases the Federal Reserve’s balance sheet will still be growing in 2014.
The arrival of the “dovish” Janet Yellen at the Federal Reserve to replace Ben Bernanke will also be supportive. The size of support that the Bank of Japan is providing is vast at $75bn a month and will eventually succeed in doubling the monetary base. This has already had the effect of improving Japanese business sentiment and the domestic economy is beginning to pick up. In the UK the mood has improved significantly and the recovery is gaining traction.
Whilst there are some justifiable concerns about the sustainability of a recovery that is fuelled by credit and a pickup in house prices, especially as wage growth has been virtually non-existent, it has to be noted that the turn in sentiment was quick caught many commentators by surprise.
In Europe any recovery will be very slow but some progress has been made. There will be much less austerity to be suffered in comparison with the last three years by the weaker nations going forward. Improvements have been made by many of the peripheral countries in terms of competiveness as wage rates have collapsed whilst Germany’s have increased.
The structural problems do however remain due to the vast disparities between countries. Also banks continue to be reluctant to lend. Although the ECB has forced down rates, the banks have not passed this saving on to borrowers who still have to pay quite exorbitant rates in the peripheral countries.
It is unlikely that this situation will improve as European banks are at present hoarding cash to store up their balance sheets ahead of the forthcoming ECB asset quality review which will examine bank balance sheets far more stringently than previously. It is anticipated that some of the Spanish banks may be found to have problems. It has to be remembered that it has been shocks in Europe which have produces significant stock market volatility over the last few years and the findings of the ECB may well prove unsettling in the spring.
One of the reasons that equities are not expected to do as well as last year is that they can no longer be described as cheap. Whilst equity valuation is a somewhat subjective affair, most measures point to them being fair value. 2013’s rally was largely due to multiple expansion and therefore we will need to see some improvement in earnings this year or otherwise there is a real danger that the rally will stall.
Some commentators feel that equities will do nothing in the first half of the year and only rally in the second half when the anticipated earnings growth picture becomes clearer. My own view is that there seems enough momentum in the present rally for equities to grind modestly higher in the short term, despite being somewhat overbought at present.
So, against a back drop of improving global economic momentum, diminishing austerity, a broadly based housing recovery in the UK and US and the expectation of some earnings growth coming through in 2014, the picture certainly appears constructive.
Furthermore the benign inflation outlook allows the central banks to persist with their low interest rate policies without losing any credibility. Given that the UK’s inflation rate is likely to be at or below the target level for the rest of this year, there is no prospect of any rate rises in the foreseeable future.
Furthermore it is likely that when rises do start to happen, they will be very gradual. There is talk in the US that rises will be in eighths and not quarters or halves and concerning Europe, there is still speculation that 2014 may be the year of negative interest rates should the forces of deflation strengthen.
We should of course stress that stock markets are not necessarily correlated with GDP growth. There are many excellent companies within Europe that have nothing to do with the domestic economy, are in good financial shape having deleveraged and still offer good value relative to the US.
As regards market negatives, investors must guard against complacency. As Ned Davis Research pointed out recently, Crowd Sentiment Indices are pointing to extreme optimism, an often reliable warning sign for markets. It does not feel as though we are quite in “bubble” territory at present but the more we rally in the short term, the more likely a correction becomes.
Concerning bonds, the logic behind the reduction in government bond index linkers at the January Asset Allocation Meeting was twofold. Inflation is likely to remain subdued for most of this year and we are wary of maintaining duration at a time when we see an upward bias to government bond yields.
Whilst the risk is likely to be closer to a 50bps rise for 10-year government bond yields and not the rather more substantial 125bps suffered last year, it will be difficult to make money at the longer end of the yield curve going forward.
In conclusion, our views can be summarised as believing that the path of least resistance for equities for the time being is upwards and that the developed markets are likely to outperform emerging markets in the short term.
Given their abject performance last year, the latter are looking extremely cheap by historical standards at approximately 1.5x price-to-book. We believe that the longer-term attractiveness of emerging markets remains, and the themes of urbanisation, rising incomes and rising domestic consumption will push prices higher over the longer term and we will therefore be looking to increase exposure at some stage this year.
We are likely to maintain our underweight to government bonds for the foreseeable future because, whilst we are not envisaging the bloodbath anticipated by some commentators, the outlook is not particularly constructive. We are a little worried that our positive equity market views appear very consensual at present and we hope that there is not a “Black Swan” event just around the corner.
