Profitable return – a rare commodity

Judging by expectations for 2014, profitable returns from asset classes look set to be rather thin on the ground. Sovereign bonds are no longer offering any upside potential so investors will be turning to equity markets in the developed world.

After posting some very handsome gains in 2013, developed-world equity markets look to offer the highest expected returns among the various asset classes for the year ahead. At constant valuation levels, returns should be capable of matching estimated corporate earnings growth.

Strategy predicated on a trio of fundamental factors

Our investment strategy for 2014 is influenced by three key factors likely to affect how financial markets behave. First, the upturn in the economic cycle is likely to continue, spearheaded by the US economy which should register steady real GDP growth around 3%. Second, profit growth generated by companies in developed economies is projected to run into double-digit rates: +10% forecast for US groups and +14% in Europe. Third, as we have outlined in this month’s ‘Topic of the Month’ article, liquidity being pumped into the system by the world’s leading central banks will have a crucial bearing on the economic and financial climate in 2014. Moreover, one other contributory factor to increased liquidity could deliver an extra boost in 2014: cash being generated by ongoing rallies on shares traded on developed markets.

This reading of the runes gives rise to two plausible scenarios for equities in developed economies. Scenario No.1 is constructed around the possibility of share prices rising at the same tempo as forecast corporate earnings growth. Scenario No.2 is predicated on the rally being even stronger, as the atmosphere on stock markets veers into ‘equity-market monomania’. This would be fuelled by market liquidity propelling a rerating via an expansion in P/E ratios. The less promising returns expected from other asset classes, like sovereign debt or corporate bonds, might well end up amplifying this whole return-chasing frenzy.

Glorious 2013 ending on a high note for developed-market equities

Gains notched up by shares in developed economies have made exceptionally good reading so far in 2013. Up to 25 November, benchmark market indices, with dividends reinvested, were exhibiting rises of nearly 20% for Europe, 29% for the US and 49% for Japan. Increases posted by emerging markets despite their energetic rebound since end-June pale by comparison: a year-to-date gain of a mere 3.2% for the MSCI Asia ex-Japan index. Earnings growth patterns contrast starkly with those trends. Forecasts for corporate earnings growth for 2013 have been downgraded during the course of the year by 12% for Europe, 2% for the US and 3% for the MSCI Asia ex-Japan index. Japan has been the notable exception as current-year corporate earnings growth has been upgraded by 14% over the year so far.

That is all in the past now as investors refocus on earnings prospects for 2014. Expectations for profit growth are pitched at around +10% for the US and Japan, but nearly +14% for Europe after two years of non-stop decreases. As the macroeconomic climate is undoubtedly improving, this projected earnings growth should indeed materialise in 2014. Results released during the Q3 2013 reporting season were encouraging, with net profits, on average, beating analysts’ expectations by 2.7% in the US, by 3.3% in Europe and by 10.6% in Japan.

Asian and emerging equity markets

News of the ambitious plan for structural reforms to be implemented in China temporarily rekindled investor confidence. The MSCI China index jumped by 8% in the three days that followed the announcement of the reform programme on 14 November, pulling up in its slipstream the MSCI Emerging Markets benchmark as it posted a 5% gain.

Risk assets stand to benefit from a revival in growth in developed economies, especially as the MSCI Asia ex-Japan index’s year-to-date performance has been so pedestrian considering the growth in net profits of almost 10%. The contrast with the MSCI index for developed markets is striking: +20.8% over the same period. Caution, however, remains the watchword with regard to Asian and emerging equity markets as plenty of risks abound: long-term below-trend economic growth; surplus credit; worsened current-account balances weakening currencies in some countries (Indonesia, India); strengthening US dollar.

US dollar on course to firm in value

The euro, with the Swiss franc in its wake, have been the only two developed-economy currencies to gain ground against the US dollar this year (+2.5% and +0.6%, respectively). The euro looked unlikely to be capable of strengthening as the eurozone economy was struggling to drag itself out of recession. The benefit of hindsight does provide some justification for its appreciation. Not only has early repayment of funds borrowed under the long-term refinancing operations led to downsizing of the ECB’s balance sheet, but, conversely, the Fed has gone on expanding its balance sheet. Rising share prices have also attracted strong flows of money into the euro.

These trends may well shift into reverse in 2014 though. The Fed will finally embark on its much talked about tapering, which will entail its balance sheet expanding less fast than during 2013. Conversely, the ECB is likely to find itself being obliged to push through further easing measures, with the upshot that assets on its books will rise. In relative terms, that state of affairs would work against the euro and to the dollar’s advantage. As for investment flows, investors are likely to focus more keenly on the US where economic growth should comfortably outstrip rates on the cards for Europe. Long-term firming of the dollar towards a value of $1.25 to the euro might well be halted though if the eurozone’s economy were to stage a spectacular upswing, similar to what has happened in the UK, but, for now, we are not contemplating that as being all that likely.

Commodities to enjoy a more stable year in 2014

Few industrial commodities have seen their prices advance this year. In the energy sector, prices of natural gas did progress by almost 14% inthe US despite the huge increase in production of shale gas. The price of WTI oil picked up by just under 4%, chiefly as it closed the gap relative to the price of Brent crude, the European yardstick. Although demand for natural resources should, on the face of it, increase in 2014 in lock-step with quickening growth in the global economy, the potential for prices to rise still looks fairly limited either on account of surplus supply or because the knock-on effect from increased demand will be counteracted by the rise in the dollar’s value, which will push down commodity prices quoted in dollars. The price of a barrel of oil should, however, hold reasonably steady or even edge up a fraction during 2014. Lastly, we remain upbeat about the outlook for palladium.

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