2014 Markets Outlook: A Year of Adjustment
A cursory glance at the global economic outlook for 2014 might lead to the conclusion that the distress of the worldwide financial crisis is finally over. GDP growth looks set to rise to 3.7 percent from 2.9 percent this year. Developed economies, in particular, are showing meaningful pickups in economic activity, with domestic demand growing in Europe, Japan and the U.S. Growth in the euro zone, Japan, the U.K. and U.S. is set to nearly double from 1.1 percent to 2.1 percent next year, compared to a more modest rise from 4.7 percent to 5.3 percent in emerging markets.
And yet. Look a little more closely, and it’s hard to get overly excited, difficult to shake the sense that the recovery’s foundation is not exactly rock-solid. The euro zone might only manage to grow 1.3 percent, and youth unemployment in the region remains crushingly high. While that’s a clear improvement over the two-year recession that recently came to an end, deflation remains a serious threat in the region, as well as in Japan. Indeed, inflation remains low in much of the world, a reflection of the fact that many economies aren’t running anywhere close to maximum capacity. In fact, the potential growth of developed and emerging economies alike is eroding, not improving, as populations age and workforces shrink nearly everywhere except Africa.
So what’s an investor to do? For now, Credit Suisse’s team recommends that investors assume that the investment environment remains similar to 2013 and position themselves to profit from strong financial markets and a continuing economic rebound in the developed world. That means overweighting equities and, within fixed income, risky credit assets. But investors should also watch carefully for signs of disappointing growth. As Credit Suisse analysts said in their 2014 outlook note, “Closer to the Top, Further From the Exit, “We do not expect returns to rise in the event of stronger-than-expected activity but think that they will fall if activity weakens.” Heads, we sort of win, tails we lose. These is not great risk-reward, but it is the situation at hand.
Central Banks Lead the Way
Five years after the crisis, the world’s largest central banks – the Bank of Japan, Bank of England, European Central Bank and the Federal Reserve – are still playing a historically disproportionate role in the global economy as well as the capital markets. “The balm of central bank liquidity has offered material comfort first to bonds and now equities,” Credit Suisse analysts wrote in the outlook note. None of the Big Four banks appears likely to hike interest rates next year. But since rates are already near zero, any monetary efforts to juice economies that still need it will require some creativity. The European Central Bank, for example, is contemplating introducing negative deposit rates. Credit Suisse believes the Bank of Japan, which pledged in April to double the size of the monetary base by the end of 2014, will likely increase monthly bond purchases by an additional 30 to 40 percent next year as well as buying billions of dollars in equities.
Just as further stimulus seems a near-certainty, so too is the fact that fears of that very stimulus drying up will likely be the primary source of headaches for investors in 2014. That will be a repeat of 2013, when concern that the Fed would begin reducing its $85 billion monthly asset purchases sparked a summer swoon in emerging market stocks and bonds while also playing havoc on spreads elsewhere. Simply put, concerns about when and how much incoming Federal Reserve Chair Janet Yellen tapers will drive returns in nearly every major asset class over the next six months or more.
That puts market participants in a rather strange position. After all, healthy growth in the U.S. is usually good news – for one thing, it stands to boost exports for America’s trading partners. It could also finally convince businesses to start spending again. In fact, higher-than-expected capital expenditures could provide potential upside surprise to Credit Suisse’s global growth forecast, Chief Economist Neal Soss said on a recent call with investors. But too much growth could pose a problem. A surge in corporate spending in the U.S. – especially if employment rises, too – would surely bring tapering sooner, de-greasing the economy’s wheels in the process. In addition, the Fed has set a 6.5 percent unemployment rate as the threshold at which it would consider raising interest rates, and with the latest reading at 7.3 percent, strong growth would surely prompt investor fear of interest rates heading higher, sooner. That would hit particularly hard in the riskier corners of credit markets, where ultra-low rates and the resulting hunt for yield over the last few years have artificially compressed spreads. “It could be a troubling year for financial markets if growth is either too strong or too weak,” Credit Suisse Global Fixed Income Strategist James Sweeney said on a recent call with investors. “I’m afraid the market side of things is going to be tough even though from a macro side, the picture actually looks pretty good.” To avoid a panic, Credit Suisse believes the Fed will get even more explicit in its assurances that rates will remain very low for a long time. The Yellen-led Fed may even go on small asset-buying sprees from time to time post-tapering, moving from the Bernanke model of very infrequent, dramatic action to more frequent, smaller interventions.
The reason the global economy has become so dependent on central bankers, Sweeney argues, is that their stimulative actions have masked the fact that the private sector’s capacity to create liquid markets has been sharply reduced since the financial crisis. Before the crisis, asset-backed securities and swaps of every flavor created liquidity for just about everything. In 2008, however, private liquidity disappeared and central banks and governments swooped in with fiscal and monetary policy to replace it. Fast forward to today: Even if the private sector can find its animal spirits again, regulators demanding higher capital ratios for financial institutions as well as new limits on trading are hampering, rather than helping, the return of privately created liquidity to its central role in the markets. For now, says Sweeney, the private sector is still not yet capable of being the financial intermediary it was before the crisis.
Sources: Credit Suisse, Federal Reserve
Having a central bank backstop means the market hasn’t yet priced in the disappearance of private liquidity, Credit Suisse Head of Strategy Research Sean Shepley says. Holding longer-dated debt, shaky credit or illiquid assets no longer pays the premium it once did, and investors aren’t getting a significantly better return by holding risky assets than they are from safe ones. Instead, assets have all been inflating together – credit spreads are extremely tight and developed market equities are up 29 percent year-to-date. The danger, Sweeney warns, is that if the Fed reduces quantitative easing in January, as Credit Suisse expects, liquidity could dry up extremely quickly. “We think the central banks have had such a strong foothold that when they adjust policy or even when they talk about adjusting policy, the effect is a cascade across asset prices,” Shepley said on a call about the bank’s outlook for next year. As a result, he cautioned, in 2014 investors need to be properly hedged against a strengthening dollar and higher volatility in interest and exchange rates due to tapering or another economic shock.
So there’s good, if qualified, news. As long as the biggest central banks keep rates low and in some cases ease further, equities have room to run, according to Credit Suisse global equities strategist Andrew Garthwaite. They’re still cheap compared to bonds, and retail investors are only starting to reallocate money to stocks. A period of consolidation – though not reaching the 10 percent threshold of a correction – is a possibility, but Garthwaite believes the S&P will hit 1,900 this year. Be prepared for a lot of sound and fury along the way.
Source of charts, from top to bottom: Credit Suisse’s “2014 Global Outlook: Closer to the Top, Further From the Exit” and slides from “Guide to Fixed Income & Economic Research 2014 Global Outlook.”