Market Bulletin – 6 January 2014 by St. James’s Place

London – From Graziano Longo DipPFS, Cert CII(MP) Senior Partner, St. James’s Place Partnership

The road to recovery

A year ago, markets and investors entered 2013 on a generally upbeat note, although this was mixed with unease over what might have been – a break-up of the eurozone or political differences plunging the US over the fiscal cliff of tax rises and spending cuts. There were hopes that the global economy would strengthen, corporate profits rise and equity markets generate healthy returns. However, in Britain, there was frustration and gloom that the turnaround was proving elusive. Optimism of the cautious variety was the attitude of the moment, based, in part, on faith in the ability of central bankers to buoy the global economy and markets.

Twelve months on and the optimism is less reserved, the global economy is on the mend and stock markets are in record-setting mode. Monetary policy will remain the focus for markets in 2014, while economic recovery in Britain and the US is underway. The US Federal Reserve this month starts the trimming of its monthly $85billion bond purchases, with the reduction of $10 billion a month an acknowledgement of and further prompt for the world’s largest economy’s move back to normalcy. Although the end of quantitative easing is now in motion, the huge quantities of easy money generated will continue to influence markets in 2014 and beyond.

Global equity markets going into 2014 have an outstanding year behind them, even when discounting the boost to returns provided by dividends. In the US, the S&P 500 index climbed 30%, while Japan’s Nikkei Stock Average index surged 57%. UK and European stocks enjoyed less spectacular but still sizeable gains in 2013, with the FTSE 100 index gaining 14% and the FTSEurofirst 300 index up 16%. And global markets last week were only slightly down from highs at the close of 2013. The S&P 500 and FTSE 100 both lost 0.3% over the week and closed at 1,837 and 6,731 points respectively; while the FTSEurofirst fell 0.2% to 1,312 points.
(Japan’s markets were closed for most of the period.)

American Way

The US equity market opened 2014 following its best annual performance for a decade with an economic
recovery to back up its advances and a clear Fed policy to help sustain its positive motion. The hope across markets is that the Fed tapering programme will be accompanied by further improvement in the economy from the housing market and manufacturing to employment levels. Although fund manager BlackRock’s chief investment strategist, Russ Koesterich, among others, points out that US stocks are no longer cheap, there is a general optimism that 2014 can still offer meaningful returns. And while we remain, as always, reluctant to predict future short-term performance, the background to support equity valuations remains in place.

There are plenty of signs that the US economy’s renaissance will gather pace in 2014. Fund manager AXA Framlington’s chief economist Eric Chaney believes that consumer spending, a more confident housing market and increased corporate investment will spur growth over the year. Meanwhile, US shale exploration and production is bringing a new era of cheap energy, reducing reliance on imports and underpinning an economic boom. Fund manager Aristotle’s Jim Henderson believes that the shale revolution will power the US economy.
“The US has an advantage in energy that’s going to last for generations,” observed Henderson.

The mix of a continued supply of easy money and economic growth in 2014 is certainly a good environment for US equities. And investors have remained constrained and are not showing the over-exuberance often associated with the end of a bull market. Among the bulls for US stocks is investment bank JPMorgan Chase which predicts that the S&P 500 index will exceed the 2,000-point mark by the end of 2014.

The crucial development for the US and global economy is whether or not the new Fed chair Janet Yellen will delay the initial interest rate rise into 2015. With the 6.5% unemployment rate threshold for the Fed to raise the base interest rate likely to be reached this year on present economic performance, financial markets can be expected to start to price in this change early, as occurred in summer 2013 after chairman Ben Bernanke indicated tapering was under consideration. The Fed has indicated that interest rates will be kept at historic lows after the unemployment rate falls to 6.5%, while markets are expecting increases to begin in 2015. The dance of central bankers and markets is set to continue into 2014.

Raising Lazarus

A heavy cloud of gloom hung over Britain this time last year, after its economy had shrunk by 0.3% in the fourth quarter of 2012 and experienced zero growth for the year. The talk was of a triple-dip recession and defeat for the UK coalition government’s austerity programme. Twelve months later and Britain is enjoying an economic turnaround few would have imagined in the dark, opening days of January 2013. Britain is one of the fastest-growing economies in the developed world and has undergone a revival that Goldman Sachs’ chief UK economist Kevin Daly has called a “Lazarus-like transformation”.

Economic historians will debate the finer detail behind the turnaround, but there is already consensus that official data did not reflect the strength of the service sector at the start of 2013; borrowing became easier and cheaper for business through the year; the government’s Help to Buy scheme injected demand into the housing market; and a stronger-than-expected employment market, despite a fall in real wages, helped boost confidence and erode consumer fears. Confidence in the economy could also bring more listings, with business consultancy Deloitte forecasting up to 100 initial public offerings in 2014.

The low interest rate environment has prompted many to spend rather than save in an almost zero-return environment for cash deposits. A housing and consumption-led boom is now expected to continue into 2014, although concerns linger over the rise in house prices from already high price-to-income ratios and consumer spending at the expense of saving. UK house prices rose 8.4% last year, according to mortgage lender Nationwide, while the 1.4% gain in December was the largest monthly rise since August 2009. Fears of a housing bubble look set to be a key area of UK policy debate over the coming year following the steady increases in house prices and the easier availability of mortgages on improved credit conditions.

The big question for markets and investors in the UK is whether the Bank of England will follow its guidance last August that it would keep interest rates at historic low levels until unemployment falls to 7%, which it initially estimated would not occur until 2016. With the UK economy growing at an annualised rate of more than 3% and unemployment falling towards the Bank’s 7% threshold more rapidly than anticipated, the Bank faces the quandary of shifting its goalposts or sticking to its new guidelines. And, while hard-pressed savers will welcome rising interest rates, the government will need to keep the consumer-driven recovery on track.

The European question

The eurozone’s recovery that started in summer 2013 has lacked the velocity seen in the UK or the US.
Although further improvement is likely over the coming 12 months, fund manager Schroders’ European
economist Azad Zangana believes that the recovery will remain sluggish in 2014. The good news is that the eurozone’s manufacturing sector has expanded for three consecutive months, although the weakness of France’s economy is a major concern for 2014. However, the consensus is that the region will experience growth of 1% or less in 2014, which is not fast enough to overturn endemic unemployment across the region.

Persistently low levels of inflation and the threat of deflation continue to hang over much of the eurozone, with all the problems this poses for tackling debt. Euro members that have pushed down wages and prices to repair competitiveness have increased the risk of deflation. Germany’s dislike of money printing is likely to curb theEuropean Central Bank’s (ECB) choice of action. While the Fed and the Bank of England are expected to raise interest rates by 2015, the ECB continues to pursue low interest rates and low inflation.

Meanwhile, investors have been moving back into Europe. A recent Bank of America Merrill Lynch survey found that global investors have increased overweight positions in eurozone equities and have an appetite for more in 2014. Eurozone stocks are still considered good value, while merger and acquisition activity has returned to its corporate landscape. Although the region trails the rest of the developed world, some of the countries worst hit by the crisis, such as Ireland and Spain, look set to pick up in 2014. And, with the ECB’s pledge to do whatever it takes to save the euro, the consensus is that a renewed eurozone crisis is unlikely.

Inflating Japan

Japanese stocks were the standout gainers in Asia in 2013. Driven by Shinzo Abe’s first year in power and decision to combat decades of deflation with a monetary stimulus programme, Japan’s Nikkei 225 notched up its largest annual advance since 1972 to end the year on 16,291 points. The Bank of Japan’s efforts last year to inflate the economy sent the yen down 19% against the dollar in 2013 and made Japanese exports cheaper.

There are major concerns, however, about the Japanese economy. The country’s corporate elite could
frustrate efforts to liberalise regulations needed to help haul the economy out of 20 years of stagnation. There is the matter of the nation’s debt and whether efforts to overcome this through a tax rise in April can work.
But there are also positive signs of inflation, rising consumer sales and export growth aided by the weaker yen.

With a stock market rally and Tokyo’s stimulus package to drive inflation to 2% over the next two years, confidence is mounting in Japan’s recovery. IMF officials are already hinting at increasing forecasts for growth of 1.2% for the world’s third-largest economy. After two decades of falling prices and stagnation, the challenge for the Bank of Japan in 2014 will be to continue to prompt companies and households to spend.

Emerging concerns

The Fed’s pullback from stimulus was greeted by global markets with relative calm, compared with the panic after Bernanke raised the prospect of a taper. However, uncertainty will linger over how emerging economies will fare as easy money dries up and western investors repatriate the funds parked in more exotic locations.

Emerging market assets were among the worst-performing in 2013. The MSCI Emerging Markets index lost
5% in 2013. Morgan Stanley identified the “fragile five” emerging economies and currencies last summer as Brazil, India, Indonesia, South Africa and Turkey. The five suffered significant currency depreciations against the dollar and falling stock markets. Each faces elections in 2014 amid inflation and a stalling of economic growth and investments – all of which will add political risks to the financial and economic threats.

Meanwhile, China will continue along its road of transition to the consumer-driven vision of the Communist Party’s reform programme. However, a debt-laden banking system, inefficient state-owned businesses and poor corporate governance remain significant obstacles. But, despite these structural difficulties and talk of slowdown, China remains on course for 7.6% growth in 2013, compared with 7.7% for 2012. That rate of growth is still at a pace that gives substance to the notion that we are in the early days of a Chinese century.

Cautious optimism

Global markets have steadily built on the hopeful, if measured, mood which marked the start of 2013. And, although the threat of short-term volatility persists, we are cautiously optimistic for investors’ prospects in 2014. And the key tenet of our investment approach remains to maintain a sufficiently diversified portfolio to balance risk and reward over the longer term. We wish all our investors a happy and prosperous New Year.

Aristotle, AXA Framlington, BlackRock and Schroders are fund managers for St. James’s Place.

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