Economic & Market Review - January 2014

by Gavin Graham, Chief Strategy Officer January 22, 2014
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The Best Year since the 1990s

Showing that forecasts about the economic and stock market outlook are about as reliable as those about the weather, 2013 ended up as the best year for major stock market indices in twenty years. At the same time, government bonds in developed markets suffered their worst performance since 1994. After a decade in which bonds had out-performed stocks by a substantial margin while being less volatile, the pattern was reversed last year. The question for pension fund trustees and other investors looking at their asset allocations at the beginning of 2014 is whether this marks the beginning of a period when stocks will consistently beat bonds and whether the weightings of these different assets in portfolios should reflect this.

As far as different stock markets performance was concerned all the major markets did well, with the exception of emerging markets, recording double-digit gains in local currency terms. In order of performance:

 Index %age gain/loss
 Japan Nikkei225 +56.7
 US S&P500 +32.4
 US Dow Jones Industrials +29.7
 MSCI World +26.3
 Germany DAX +25.5
 France CAC40 +22.2
 UK FTSE100 +18.7
 Canada S&P/TSX Composite +13.0
 MSCI Emerging Markets -2.6
 Bloomberg US Treasury Bond -3.4

The reason that bonds did so badly was that long term yields rose by more than 1% in the US and by between 0.4% in Germany and 0.8% in the UK in 2013. With 10 year US Treasury bonds beginning the year yielding only 1.9%, any upwards move in yields was likely to lead to substantial falls in the price of long dated bonds, whose prices move inversely with yields, so that when interest rates rise, bond prices fall.
The very strong stock market returns were not driven by any major growth in earnings, as, although the US, the UK and Canada are expected to have experienced GDP growth of more than 2% last year, this did not translate into strong growth in profits for companies, whose profit margins as a share of GDP are already near 80 year highs. Instead, investors were encouraged by signals from the US Federal Reserve (the Fed) that it would be cautious about withdrawing its monetary stimulus known as Quantitative Easing  (QE), which saw the Fed injecting U$85 billion a month into the markets through purchases of Treasury bonds and mortgage-backed securities. In the meantime, the European Central Bank (ECB) reduced interest rates to 0.5% and the Bank of Japan expanded its monetary base even faster than the Fed, while weakening the Japanese yen by 25% over the year, to stimulate the economy and bring an end to deflation.

When the Fed did indicate that it would begin to reduce stimulus (“tapering”) later in 2013 in May, markets had their worst sell-off of the year. While the US, Japan and European markets rapidly recovered, especially after the Fed backed away from tapering in September, emerging markets, especially those countries which had large current account deficits funded by short term inflows of foreign money seeking higher yields than the 0.25% available in the US, such as Brazil, India and Turkey, experienced a heavy sell-off. As a result, emerging markets experienced a decline in 2013, with China's slower GDP growth rate of 7.6% contributing to concerns over whether developing economies had passed their peak.

This also affected the price of commodities and the performance of economies such as Canada whose stock market had heavy weightings in resource stocks. Gold experienced its first decline for a decade falling over 25%, while base metals and coal, driven by demand from emerging markets, also saw declines. Oil however, remained around U$100 a barrel in the US and U$110 in Europe, held up by concerns over unrest in the Middle East and continued strong demand from consumers in emerging markets, where China became the first country to sell over 20 million vehicles in 2013.

For 2014, investors should expect continued moderate GDP growth in North America and Japan, bolstered by a recovery in continental Europe as fears over the future of the Euro-zone decline. While at the margin, further tapering by the Fed and other central banks should prove a headwind to further gains in markets, the authorities such as the new Fed Chairwoman, Janet Yellen and the head of the ECB, Mario Draghi, have made it plain they will be very cautious about tightening liquidity let alone raising short term interest rates. With mid term elections in the US and European elections due this year, it is reasonable to expect that central banks everywhere will take a gradual approach to tightening. 

Investors therefore are probably going to enjoy a similar experience to last year in a muted form, with smaller rises in stock markets and smaller declines in bond markets. However, the pattern has been established; investment grade fixed income, especially long dated government bonds, look vulnerable as governments continue to encourage inflationary measures and borrow heavily, even five years into the post Lehman Bros. recovery. While a balanced portfolio containing cash bonds and equities remains the mainstay of any investor’s asset allocation, corporate obligations, whether investment grade or high yield bonds or equities, should have a larger weight than a couple of years ago.

Source: current as of January 21, 2014