Equities are set to rise further in 2014 after the world returns to normality, with higher global growth and the end of easy money in the US. These are the key predictions of Robeco’s Chief Economist Léon Cornelissen in his outlook for markets next year.
Favorable climate for higher-risk investments
Stocks are Robeco’s preferred asset class for 2014, although returns may not be as strong as in 2013, when the MSCI World Index rose almost 16% in the first 10 months of the year in euros on the back of stimulus from quantitative easing (QE) programs.
“2014 will be a year in which higher-risk investment categories will provide satisfactory returns,” says Cornelissen. “Expanding global growth combined with continuing loose monetary policy favors higher-risk asset classes.”
High-yield bonds are favored in the fixed income sphere, as the end of QE – beginning with tapering by the US Federal Reserve (Fed) expected from the Spring – signals a new era of rising interest rates. This makes the returns on high-yield debt relatively more attractive than those available on sovereign bonds.
‘Less emphasis on austerity will support recovery in the Eurozone’
Politics will be the unpredictable part
However some political risk remains. The Eurozone has come a long way since the height of the euro crisis in 2011, with growth expected to rise towards 1% in 2014. “Less emphasis on austerity will support recovery in the Eurozone”, says Cornelissen. “This will mean that earlier deficit targets will again not be achieved.”
“It is nonetheless very unlikely that the European Commission will impose fines on miscreant nations; just as unlikely is a fine for Germany because of its continuing excessive current account surplus. Although in theory the Commission's powers for achieving a more centrally directed budget policy have increased greatly in recent years, these will still turn out to be a paper tiger in practice, due to the lack of political support. The outcome of the European parliamentary elections in May 2014 will be an unsurprising but still unpleasant confirmation of this lack of support”, says Cornelissen.
The US also faces the potential wrath of voters after the world’s largest economy only averted debt default when the government was shut down amid wrangling over raising the debt ceiling. US Congressional elections will take place in November, potentially dislodging those Republicans who had opposed Democrat President Barack Obama during the shutdown.
Three scenarios for quantitative easing
With regard to quantitative easing, there are three different scenarios, with differing likely outcomes. “Quantitative easing will come to an end in the US, will probably not start in Europe, and will be expanded in Japan,” says Cornelissen. He predicts that tapering the Fed’s QE program will cut the value of government bonds purchased from USD 85 billion a month to zero over a period of six to nine months from March or April. “Limited long-term interest rate rises in the Eurozone and the US are likely, but this will probably not happen in Japan because of financial repression,” Cornelissen says.
That is because the extraordinary Japanese economic experiment known as ‘Abenomics’, in which Prime Minister Shinzo Abe has combined QE with an assault on deflation and a pledge for structural reform, faces its biggest test next year. VAT will be raised by three percentage points in April to encourage greater spending in the first quarter, thereby averting deflation. But it runs the risk of triggering a recession similar to the one that followed the last VAT-rise experiment in 1997.
In the long-embattled Eurozone, Cornelissen expects “moderate economic recovery”, eventually rising above 1.0% a year. However, the chief economist warns: “Positive investment growth is also necessary to achieve recovery in the region. And it is necessary to control political tensions for this recovery to work.”
Japan GDP Growth Rate
Figure 1: The Japanese VAT hike risks putting the country back into recession. Source: www.tradingeconomics.com | The Cabinet Office.
Mixed bag for emerging markets
Globally, Cornelissen expects “moderately increased growth in the developed economies outside Japan”, but the picture for emerging markets is expected to be mixed.
“China will slow down to some extent, while other emerging markets will speed up to a limited degree”, says Cornelissen. “Accelerated Chinese growth is not sustainable and the authorities are again taking the path of monetary tightening. All in all, we are counting on growth in the order of 6.0% against 7.5% in 2013”.
“Because of the economic recovery in the developed world, we believe there is a plausible case for limited recovery in Brazil (where there are also elections in 2014), India and Russia.”
Earnings will be key to success for stocks
“Overall, the macroeconomic climate will be more favorable for stocks in 2014 than in 2013,” he says. “Gradual interest rate rises in a low-interest rate climate are a positive signal that the US economy is in principle strong enough to support corporate profits by increasing consumption and investments. But earnings will be the key to success in 2014.”
Figure 2: Profit margins have steadily risen for US companies since 2009. Source: Bloomberg / Robeco.
Equity price rises in 2013 were mostly driven by stocks achieving higher multiples – a company’s share price divided by its earnings per share – as both profits and business sentiment generally improved due to stimulus from QE. This may not be repeated next year when QE begins to be withdrawn, Cornelissen warns.
“We expect to see a more gradual expansion of price/earnings ratios, modest profit growth and somewhat greater market volatility,” he says. “These factors will make it difficult for stocks to equal or exceed their excellent 2013 performance in 2014.”
Bond yields will gradually rise
In fixed income, high-yield bonds are preferred. “Low interest-rate policies in recent years have given businesses sufficient opportunities to issue longer-term bonds at favorable rates,” says Cornelissen. “Still, we note that this asset class is losing some of its glamour. The reward for credit risk has dropped to 450 basis points and therefore lies below the 10-year average of 610 basis points.”
For emerging market debt, the current return on credit risk is 500 basis points. While this is 50 basis points higher than the equivalent return on high-yield corporate bonds with a similar duration, Cornelissen does not believe it will compensate for the significant currency risk seen in 2014. This is due to emerging markets currencies continuing to devalue against the US dollar as they struggle with economic growth.
“As emerging markets catch up economically, the current undervaluation of currencies (at this time over 40% based on purchasing power parity) will gradually translate into currency profits and offer solid returns on emerging market bonds in the longer term,” Cornelissen says.
For sovereign bonds, the Fed’s tapering plans mean higher yields - and bond values falling in tandem - as interest rates gradually rise.
“Both US and German government bonds are approximately 100 basis points lower than one would expect due to money market interest rates, inflation and growth prospects,” says Cornelissen. “We expect that bond yields will gradually increase during 2014 towards the levels that would be appropriate with further increasing economic growth".