2014 could be another good year for equities

by Dominic Rossi, Global Chief Investment Officer, Equities at Fidelity

January 2014

Global stock markets had another stellar year in 2013 as the S&P 500 Index notched record after record. Investors are likely to remain well disposed to equities in 2014 due to the same underlying reason – the prospect of sustained economic progress in the US.

Indeed, the US economy is as healthy as it has been in the past 20 years thanks to the structural improvements in its fiscal and trade deficits. In 2009, the US fiscal deficit was 10% of GDP, or about US$1.5 trillion (A$1.7 trillion). By 2015, this shortfall is forecast to be only 3% of GDP, which is comparable to trend GDP growth and allows the US to stabilise its debt levels. For the first time in 30 years, the trade position has improved during a time of economic growth and the reason for that is shale energy. These narrowing deficits have helped to stabilise the US dollar, which is one of the reasons commodity prices and some emerging markets have been under pressure.

The rally in the US stock market has helped restore the confidence and net worth of consumers. One important point to recognise about the US stock market is that it is a source of economic strength as well as an outcome of it. A hefty chunk of US wealth is invested in the stock market and, despite wealth inequalities, a rising stock market helps the economy. We now have the prospect of the US economy growing at a sustainable 3% real rate in a low-inflation environment, which means the Federal Reserve can afford to prune, or taper, its asset buying. This is a broadly supportive environment for developed world equity markets.

A further rerating of equities is possible but there is less potential for earnings growth to take stock prices higher. The US is the place likely to deliver the best earnings growth, but generally stock prices will rise faster than profits. It follows that valuations would move higher and investors should be aware that there is some risk that equities could become expensive and prompt corrections.

Worrying Europe

While investors can expect the US economy to expand, nominal economic growth will remain low. As inflation is generally tame across major economic areas, the logic for tighter monetary policy is simply not there. Discussions about the rapid normalisation of rates appear overdone. Real interest rates are likely to remain negative for some time given the debt dynamics of developed economies. Public debt levels today are higher than they were in 2008 due to the transfer of debt from the private to the public sector.

Despite the pressing need, the tapering or the unwinding of quantitative-easing support will be a focus in 2014. Once tapering begins in the US, it will present a bigger challenge to Europe than it does to the US because of the deflationary dynamics in Europe. Given that the US labour force participation rate is historically low – having fallen to a 35-year low in 2013 – and real incomes are not growing in the US, there is little to prompt the Fed to taper. It would be best to see 3% growth and material improvements in employment before tapering begins.

Although we’ve seen some incipient signs of recovery in Europe, this should be viewed as a statistical event coming off extremely low levels of growth. There is little inventory in Europe, so even a slight shift in demand affects industrial production and growth. A modest cyclical improvement should not be confused with a structural recovery, as the preconditions are not yet in place for the latter to occur.

This broader structural adjustment process is expected to persist for another two or three years. While there has been some progress, such as with unit labour costs in the peripheral countries, it has come with high social costs and there is still the risk that Europe faces a deflationary future given government policies. An inflation rate of close to 0% is not inconceivable next year. Nominal economic growth could thus amount to around 1%. Given that 10-year government bonds are in the region of 4.1% in countries such as Italy, the debt problem is worsening. Countries need primary surpluses just to even out the compounding interest effects. This makes it hard for Europe to grow out of its debt problems. Investors can expect some form of debt default (via rescheduling or restructuring) sooner or later in the eurozone. The key weakness for Europe’s equity market remains an undercapitalised banking system exposed to peripheral sovereign debt risk. Our research shows that while the strong banks have become healthier, the weak banks are in worse shape.

The improvement in European equity markets seen thus far has been largely driven by rebounding or economically sensitive areas with low returns on equity such as Greek banks. This is not the kind of rally to get excited about. The euro at its current level also represents something of a headwind to further progress. Valuations remain attractive, however, and half of the stocks in the European market have a dividend yield above the yield on credit, where yields are close to historic lows.

Hope you have a good weekend,

 The team at IPS