As the New Year dawns, it is difficult to escape the conclusion that the outlook for equity markets, in the near term at least, looks extremely favourable. Growth in developed economies is accelerating which should, in time, translate into decent profits growth for listed companies, whilst upward pressures to inflation look close to non-existent. In these times of extraordinary fiscal and monetary policy, this is surely as close as it will get to a so-called ‘Goldilocks’ scenario where the global economy grows at a pace which is neither too hot, nor too cold.
Furthermore, the positive reaction by investors in riskier assets to the announcement of the beginning of the end of QE in the US is to be welcomed as it suggests the ‘crowd’ believes that the global economy is now resilient enough to accommodate tighter US monetary policy.
However, the strong showing of equity markets in 2013 has not been followed through with upward earnings revisions, indeed analysts’ forecasts for company profits were cut as the year progressed. This is quite normal as analysts are habitually too optimistic at the beginning of the year, and investors have got used to this behavioural bias. However, given the strong equity market performance during 2013 (FTSE All-Share Index 12-
month total return: +20.8%), the stock market (relative to underlying aggregate company profits) has become significantly more expensive as investors anticipate company earnings rising in the future.
We believe that equity investors’ greed will dominate their fear in the near-term, and that developed market equities will continue to rerate upwards given the improving outlook. However, by the second half of the year it will be vital that the anticipated earnings growth does actually translate into real company profits growth, in order to sustain the market going forward. We believe that it will, but it is here that a key danger to equity markets in 2014 lies.
The scope for the greatest positive surprise to economic growth resides in the eurozone, where only anaemic growth is forecast. If we are right about the impact of the structural changes that are occurring in the eurozone and the scope for economic growth in the rest of the world to pull the eurozone up, 2014 could be a bumper year for the undervalued eurozone equity market. We also believe that commentators have talked down the prospects for emerging market economies to such an extent (due to the threat of tighter monetary policy in the west) that investors have become too pessimistic about the prospects for these equity markets and are now extrapolating a scenario that is worse than current consensus forecasts suggest. This means that should the economies achieve what we think are fairly modest analyst forecasts then a positive surprise can ensue.
Gilts sold off significantly during 2013. Such that the yield on the 10-year gilt rose from 1.8% at the beginning of the year to 3.0%. What is interesting here is that over the same period headline Consumer Price Inflation has fallen from 2.7% to 2.1%. Some commentators are expecting the rate of inflation in the UK to reduce further during 2014. This means that for the first time in over 3 years one can construct an (albeit simplistic) argument that 10-year gilts are no longer out-and-out expensive. With developed economies continuing to improve during 2014, we believe that gilts will continue to underperform in 2014, however the level of underperformance should not be of a scale that could derail equity markets as upward inflationary pressures are well contained.
Returning to the Goldilocks analogy, the major risks to equity markets are either that economies begin to grow a little too fast for comfort or conversely that the economic revival falters. Should economic growth accelerate significantly faster than current expectations, market participants will bring forward their expectations of when and by how much central banks will increase interest rates. After an initial period of indigestion,
continued evidence of the resilience of the recovery would be embraced by equity investors. Should economic growth stall and inflation start to surprise (in a sustained manner) to the downside, then the spectre of both further cuts in earnings forecasts and (just as importantly) deflation will rise once again. Any impact here would be cushioned by the vigorous application of further monetary and fiscal stimuli.
These risks should not be downplayed and either scenario would have a material (if transitory) impact on market levels. However it is our belief that we are some time away from having to take a view on either one of these issues, and that in the interim equity markets can continue to move higher.