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Marcuard's Market update by GaveKal Research
For the first time since 2008, investors, economists and business people can say “Happy New Year” without irony. While last year was statistically disappointing, with global growth slowing slightly from 2012 and apparently belying the optimism we expressed last January, the verdict of financial markets and business sentiment has been much more consistent with my predictions. Stock markets enjoyed their best performance since the 1990s, long-term interest rates soared and consumer confidence all over the world ended 2013 much higher than it started. This apparent paradox is easily explained: the statistical weakness of 2013 was due entirely to a very weak period last winter, connected with the presidential elections in the US and leadership transition in China. By the second quarter, growth had revived in the US and China and accelerated strongly in the UK and Japan. Strong global PMIs reported last week confirm the momentum.
That conventional wisdom last January was far too pessimistic about the economic outlook is evidenced by the subsequent behaviour of financial markets, where equities outperformed bonds by the biggest annual margin on record. But today almost everyone is optimistic. So, what unexpected developments could surprise financial markets and business sentiment in 2014? Below are five guesses – some possibly farfetched and others seemingly obvious, but none yet fully reflected in market prices:
1. Four is the new two. The US economy will probably grow by about 4%, much faster than the 2.5% to 3% predicted by the IMF and mainstream economic forecasts. The reasoning is simple. In the last reported quarter, the US economy was already growing by 4.1% and the private sector by 4.9%. With US budget battles now over and short-term interest rates firmly anchored at zero, there is no reason to expect a slow-down. If the US accelerates to around 4%, so will global growth—and 4% will replace 2% as the growth rate assumed in business and financial planning. Global inflation expectations will also bump up to around 3%, raising the benchmark for global growth in nominal terms to around 7%, very similar to the ten years before the 2008 financial crisis. In other words, the “new normal” of global stagnation widely predicted after the crisis will turn out to be not very different from the old normal.
2. The big financial trends of 2013 still have a long way to go. While the gains of over 20% in major stock markets may not be repeated this year, equity prices in most of the world should continue rising – and bond prices continue falling. Stock market optimism seems justified for two reasons. Wall Street has now decisively broken a 13-year trading range and past experience, as described last year in our article This Is Not A Peak: It’s A Bull Market, strongly suggests that this break-out signals the start of a bull market in global equities that will last for many years. Shifting from history to financial fundamentals, the 7% nominal growth we expect in the global economy should translate into similar growth in corporate revenues and earnings. That would imply similar gains in equity prices, even without any increase in price-earnings multiples or leveraging up of corporate balance sheets through stock buy-backs. Given that equity valuations are still only slightly above long-term average levels and that companies are flush with cash, there should be scope for considerably stronger gains in many stock markets. The biggest problem for stock markets will be higher interest rates, since 10-year yields will rise to at least the 3.5% as the US economy accelerates. But history shows that stock market prices usually rise alongside rising bond yields during periods of economic recovery, provided short-term rates remain low. And luckily for equity investors, the Federal Reserve will maintain its commitment to zero short-term interest rates however much the economy accelerates, because Fed officials see rapid growth as a natural and welcome development after five years of deep recession.
3. The European crisis will metastasize from economics into politics. Unfortunately, European central bankers have a very different world-view. They see rapid growth as a portent of inflation and will start hinting at tighter money as soon as economic conditions improve. The conflict between strong growth and easy money has already appeared in Britain. It will become a major political problem in 2014, because the improvement in economic activity depends entirely on a property boom which the Bank of England is trying (unsuccessfully) to deflate. As a result, sterling will continue to strengthen, central bank independence will come under pressure and the British economy will become ever more unbalanced, generating the world’s biggest trade deficit relative to GDP. In the eurozone, by contrast, economic conditions will remain feeble at least until the summer, when a shift towards more expansionary monetary and fiscal policies will be triggered by panic in Germany about the big victories for fringe nationalist and neo-fascist parties in May’s European elections. As a result, the euro will weaken and the southern European economies will finally start to recover, but not until the second half of the year.
4. Japan will shoot itself in the foot – again. Japan is the major economy most likely to disappoint expectations in 2014, making a mockery of the optimism expressed here last year about Abenomics. The consumption tax increase in April will produce a fiscal tightening worth roughly 2% of GDP, after allowing for some feeble offsetting measures. As a result, Japan will probably sink back into recession by the second quarter and the stock market will fall sharply, even though the Bank of Japan will try to ramp up its monetary stimulus and the yen will probably weaken even more.
5. Emerging markets will make a comeback—perhaps in unlikely places. With the US accelerating to 4% and China growing steadily in the 7% to 8% range, emerging markets will come into their own as investors realise that most of these economies have more to gain from robust economic conditions and stronger commodity prices than they have to lose from slightly higher interest rates. There will, of course, be exceptions. Financial problems may intensify in countries with large trade deficits or political mismanagement, such as Turkey and perhaps Brazil. On the other hand, two major economies now treated as pariahs could do surprisingly well. In Russia, the recent release of businessman Mikhail Khodorkovsky could signal a newfound respect for private property rights. And a nuclear deal with Iran could bring this potentially dynamic economy back into the civilised world, and transform Middle East geopolitics. But at this point, we are probably getting too optimistic even for a New Year pipedream.
