18th December 2013
Investors are now turning their attention to 2014 and the type of market environment that may lay ahead. 2013 has been kind, with significant growth in equity markets and only minimal falls in certain bond markets. However, markets have now moved significantly higher and stock markets are no longer as compelling value as they were at the start of 2013. How should investors approach their portfolio construction for next year? Investment journalist Cherry Reynard reports.
Whatever the type of investor, there are a few key themes to bear in mind:
1) The smart money is on it being a year of higher growth. The central scenario for most asset allocators is for higher growth. Stephanie Flanders, strategist at JP Morgan Asset Management, points out that nine out of 10 of the major developed economies are in expansion mode going into 2014. She adds: “The US grew very rapidly last in spite of some monetary tightening and some fiscal consolidation. If the US can do it with that amount of austerity, imagine what could happen without it.”
Andrew Bell, chief executive of Witan, says that while the outlook for global growth may have moved from ‘rigor mortis to anaemia’, it is nevertheless a significant improvement on last year. Headds: “Over the last 18 months, it has become clear that central banks do not plan to put interest rates up at the first sign of economic growth.” This is a clear boost for growth prospects.
2) Safety is still relatively expensive, particularly for fixed income. There has been measured slowdown in fixed income since the Federal Reserve hinted that it may taper quantitative easing, but government bonds still look unattractive. At a yield of 2.9% for 10 year gilts, this is just 0.7% ahead of current inflation. Although a rise in interest rates still appears to be some way off, the risks in government bonds are asymmetric – a lot of downside with little upside except return of capital. Investors need to be sure that they need safety – i.e. that the economic environment may be deflationary – to take those odds.
The same is true to a lesser extent in equity markets. Investors are still paying a premium for ‘safe’ companies – consumer staples, utilities and other areas that have offered consistency of earnings in an uncertain backdrop. Recently Neil Woodford, manager of the Invesco Perpetual Income and Higher Income funds, said that he considered valuations on typical equity income stocks expensive.
As he told Trustnet: “We would caution, however, that returns over the next three years are likely to be somewhat lower than over the last three years, purely as a consequence of the higher valuations that we now see in our market”. In an expanding economic environment, all companies find it easier to grow earnings, so investors should ensure they are not paying too high a price for safety of earnings.
3) Almost nothing is cheap…..Corporate earnings have to come through to justify current equity market valuations. Alex Crooke, fund manager on the Bankers Investment Trust, says: “I would tone down my positive view on the outlook for next year if earnings don’t come through as expected.” Bell agrees saying that investors had some protection if earnings did not come through last year as valuations were low; they do not have the same protection this year.
4) …..but emerging markets, commodities and Europe are cheaper than most. These areas have all seen significant relative falls in valuation: Commodities have been hit by the prospect of the end of era of ‘loose money’ as the Federal Reserve pares back quantitative easing, emerging markets by the weakness of China and Europe by the ongoing debt crisis in the Eurozone. These may provide fertile hunting ground if the global economy improves.
5) QE – the tapering thereof, and its impact on economic growth is likely to have the biggest impact on markets in 2014, barring any ‘unknown unknowns’. However, investors should probably not over-estimate its importance. Crooke says that barring any dramatic miscalculation by the Federal Reserve, the impact of the tapering of quantitative easing is likely to be largely confined to the US market.
6) Japan is important – Japan’s economy is in the last chance saloon. If Abenomics doesn’t work, there is no plan B. Quantitative easing in the country should help the global flow of liquidity, and if it generates stronger growth in Japan, it would be a real boost to global growth. If it doesn’t, Japan is effectively resigning itself to permanent deflation and it would drag global growth down with it.
7) Europe is not out of the woods – The Eurozone remains the biggest concern for the majority of asset allocators. Bell says it is his greatest concern with a number of elections coming up next year, which may be used as a protest vote against the Eurozone.
Barring a significant shock, these themes should guide portfolio allocation in 2014. Next up, portfolio allocation in 2014 for income and growth investors….