What Investors Should Expect in 2014

On one hand judging by what happened in 2013 we should expect the unexpected. This time last year we faced clouds on the horizon – a potential triple dip recession in the UK, a hard landing in China, further crisis in the EuroZone, the fiscal cliff in the US and an unknown outcome of Abenomics in Japan. In the end none of these issues led to financial storms and surprisingly it has turned out to be a pretty good year. Who would have thought the Japanese economy would be emerging out of a deep freeze and the UK would be recovering strongly, so much so that there are fears of a property bubble?

On the other hand there is a known looming threat. I listened to a recent webcast from Old Mutual Global Investors in which four fund managers were asked for their views on the global economy and markets for 2014. The overriding financial issue that concerned them was tapering of Quantitative Easing in the USA. QE through money printing and asset purchases has artificially depressed bond yields by pushing up prices. It is a manipulated market and the consequent rally in bonds and equities has been liquidity driven with easy money, rather than determined from fundamentals of economic growth and company earnings.

Now there are signs of economic recovery in the US and other parts of the world, QE needs to be turned off to allow bond markets to return to normal. However if QE is not gradually reduced with clear forward guidance there could be a sharp sell-off in the bond market. We had a sign of this in late May after Ben Benanke, Chairman of the US Federal Reserve stated tapering of QE could begin shortly. Bond yields shot up and capital exited emerging markets. Mortgage rates rose in the US and demand for home loans fell, threatening the consumer economy. Equities fell over the summer but in developed markets they have since rallied. In contrast bond yields remain above their pre-Benanke sell off levels.

So what could happen? If QE is tapered in a controlled and pre-determined way, for example if it is reduced from the current $85 billion per month by $5 billion p.m. for 17 months markets might react well. Bond yields would rise steadily but equities could still do well. If markets react badly to QE tapering a sharp bond sell off would drag equities down as well. As Stewart Cowley, leading bond fund manager at Old Mutual observed – bonds are the senior asset class. One reason here is the size of the global bond market is larger than the equity market. How QE tapering is handled by the Federal Reserve is the crucial issue in the first half of 2014, as is the US debt ceiling, which like the proverbial can keeps getting kicked down the road.

In Europe the French economy is a source of worry and Italy is also a concern with the third largest bond market in the world. The EuroZone was quiet in 2013, perhaps not in 2014. I don’t think the crisis is over yet.

Looking beyond these early 2014 events in the longer term asset prices should be determined by fundamentals. It is somewhat ironic that in May markets reacted badly to suggestions of tapering of QE, when clearly withdrawal of life support means the patient is making a recovery. With such a mind-set good economic data is perversely greeted by investors with fear, that QE tapering will commence sooner than expected.

So what do I conclude. If there is a sharp sell-off, bonds and equities will move down in tandem. However markets should subsequently return to fundamentals and unless the sell-off in assets leads to another serious financial crisis or global recession, equities should rally and do well in the medium term on the back of global economic recovery. Equities remain my favoured asset class for capital growth and income growth whilst bonds should be avoided except for investors needing a high income.

Due to my trip in January this will be the last investment blog until at least February.  I wish you a very happy Christmas and all the best for 2014.

This blog is intended to be a general investment commentary only. You should seek individual financial advice before making investment decisions.