The five risks markets may face in 2014

1st January 2014

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In many ways, 2014 looks set to be a barnstorming year. Economic indicators are pointing higher, equity market valuations are high, but not excessively so, while interest rates show no signs of rising and inflation appears to be under control. But unlike 2013, equity market valuations now leave relatively little room for manoeuvre and a robust appraisal of the risks will be vital. With that in mind, investment journalist Cherry Reynard gives her view of the top five risks for 2014. 

1) TaperingThis is likely to be the key swing factor for markets in 2014. The Fed has now announced a pared back quantitative easing programme, buying back $75 billion a month in mortgage and Treasury bonds from January onwards, down from $85 billion. Monthly purchases will then be cut by increments of $10 billion at subsequent meetings. The Federal Reserve said moves will be measured and dependent upon further economic progress.

The early reaction from equity markets was muted enthusiasm. Dan Harlow, deputy manager of the AXA Framlington American Growth fund, says markets were buoyed by the relatively small cutback in monthly bond purchases, as well as by the Fed’s commitment to maintain a pragmatic approach going forward: “Importantly the tapering announcement included a pledge to maintain interest rates at their present level until “well past the time that unemployment declines below 6.5%””

However, risks remain that US growth may not be sustainable if policymakers taper too much and too soon. Equally, the tapering of quantitative easing may continue to push pressure on emerging market currencies, which had been a key beneficiary of the liquidity it provided. The Federal Reserve is treading a fine line.

2) Valuations – global earnings have been downgraded through the course of 2013, while equity market valuations have risen, says Alex Crooke, portfolio manager on the Bankers Investment Trust, He is optimistic that corporate earnings will improve in 2014, driving stock market performance, but adds that should these not come through, it would cause him to revise his current positive outlook for equity markets in 2014.

Equity market valuations no longer leave a lot of scope for disappointment. As at 19th December, the S&P 500 was on a dividend yield of 2.3% and a P/E of 18.6x; this time last year, the same figures were 2.6% and 15.2x. For the UK the yield on 19th December last year was 3.4% and the P/E 12.6x, while the yield is now 3.2x and the P/E 14.1x. The phenomenon has been seen even in Europe. The Dax 30 is now trading on 15.6x earnings, compared to 12.4x last year.

3) European elections – Elections for the European parliament take place in 2014. the European situation is still sufficiently precarious that the elections may be used as a protest vote by those unhappy with the course of greater European union. Banking union is now agreed in principle as the Telegraph reports. There is a danger that rogue parties, and extremists of varying colour gain a greater political voice.

There are also problems elsewhere. Stephanie Flanders, chief market strategist for UK and Europe at JP Morgan Asset Management, points out that there is still a difficult dynamic between the core and periphery in Europe. Corporate borrowing remains significantly more expensive in the periphery than in the core, but the gap has started to narrow. Nevertheless, it remains a significant challenge and small and medium-sized enterprises continue to be disproportionately affected, stalling the recovery. The US tightening might imperil this further.   

4) Disappointing growth in the USStephanie Flanders, believes that there are risks on the supply side and economic growth may not come through as expected. She says: “There is a certain expectation built into financial markets. If there was bad news from the supply side. It would test the proposition that we can go back to some kind of normal economic situation. If there really isn’t a lot of spare capacity in the economy, we might not get the year we think.”

5) Conflict between China and JapanEquity markets have grown used to conflict in certain parts of the world. However, the current spat between China and Japan is likely to be more disruptive for market sentiment if not for actual economic progress: . The two sides have engaged in increasingly bitter exchanges over uninhabited islands in the South China sea as the Times of India reports.

Crooke says: “If it becomes a ‘hot’ war, yes, it would be profoundly damaging.” But he adds that while both sides want to look ‘strong’, each realises the negative repercussions of escalating the conflict.

For some external views on the biggest risks of the year, these sites have some useful insights: Manulifeam.com and zero hedge.

Equally a recent poll of investment trust managers by the AIC gave the following results: “For example, 20% worry that equities are perhaps not as good value as they have been.  Some 15% of managers think that tapering of US quantitative easing could be a potential cloud on the horizon next year, 10% cite geopolitical instability and 10% of managers also think high inflation could be a potential risk.” 

It is also worth adding those much-discussed areas that aren’t likely to be risks in 2014: UK house prices, for example, are undoubtedly inflated, but don’t look like going anywhere – the bubble has been largely confined to London and portfolio managers are generally untroubled by rising prices. Equally, rising interest rates also appear to be a long way off and are unlikely to be a risk for 2014, though as ever, speculation about rising interest rates might create disruption. As with every year, the greatest risk is of the proverbial ‘unknown unknown’ – that elusive risk that no-one knows is coming.

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