Comment from Rob Morgan, Pension and Investments Analyst at Charles Stanley Direct
2013 turned out to be a great year for many investors. An improving economy, buoyant equity markets and plenty of successful flotations, notably Royal Mail, have given the start to 2014 an air of confidence. Markets like to climb a “wall of worry”, something ably demonstrated over the course of last year. Yet now asset prices are higher, the risks are greater, and some of those worries haven’t gone away. While momentum seems to be behind the market, meaning 2014 could also be a decent year, I will be keeping an eye on the horizon for any looming risks, the key ones in my view being the following:
Risk #1: US Treasury yields rise further
Equity markets rallied at the end of 2013 as the US Federal Reserve announced it would taper quantitative easing, but that interest rates were still a long way from rising – they are now tied to unemployment figures rather than inflation. However, markets could be less relaxed if US inflation surprises significantly on the upside. Although this might be a sign of the economy improving more quickly, any heavy selling of US Treasuries could result in higher yields, likely denting bond and equity markets around the world.
Risk #2: Earnings don’t live up to expectations
The prevailing view is that economic growth is sufficient to allow corporate earnings to rise and inflation expectations will remain mild enough for central banks to maintain an accommodative stance. Yet earnings could disappoint if growth turns out to be weaker than anticipated. A number of fund managers are telling us that decent earnings growth is already factored into prices – it needs to come through for equity markets to continue forward momentum.
Risk #3: UK inflation scare
Like the US, UK interest rates are increasingly linked with jobless numbers and we don’t expect them to go up before mid 2015. Yet investors should not take this for granted. Weakness in oil and other commodity prices combined with a strengthening pound over the course of 2013 may have given us a false sense of security with regard to our own inflation numbers. If these trends reverse, Governor of the Bank of England, Mark Carney, may have to make the uncomfortable decision to raise rates, albeit very slowly. Good news for savers, bad news for borrowers, and it could stop the recovering housing market in its tracks.
Risk #4: Eurozone crisis reasserts itself
Investors put the Eurozone crisis from their minds in 2013. Yet major nations including Spain still face huge challenges getting their economies back on track while keeping on top of their debts. As a whole growth in Europe remains febrile and it remains a possibility that bond yields for problem nations could spike once more, whether due to political issues or a deteriorating economic picture. A return of the Eurozone crisis would hit activity in the region and confidence worldwide, likely resulting in investors fleeing to safer assets. However, it could also mean the European Central Bank finally draws a line under the crisis and resorts to full blown quantitative easing or something similar.
Risk #5: “Abenomics” fails
I am bullish on Japanese equities as few investors seem to believe the Japanese economy really can turn the corner. However, I have to accept that this scepticism could be warranted if Prime Minister Abe’s initial success at boosting growth and inflation through the devaluation of the yen is not followed up with proper structural reform. Perhaps the most difficult step will be raising consumption tax without dampening domestic activity too much. Furthermore, if the economy deteriorates there is only so far Japan can go in terms of weakening the currency further without incurring trade restrictions.
Risk #6: Financial crisis in China
The true nature of bad debt in China is unknown. There is an unregulated ‘shadow banking’ system where credit growth is hard to gauge. The biggest risk perhaps is in so-called “wealth management products” issued by banks and other investment companies. There are short term savings vehicles that offer high rates of return but are sometimes based on financing risky enterprises from property and infrastructure to car dealerships and pop concerts. Regulators seem to be intent on reining in mushrooming credit growth, but who takes the loss on existing bad debts or financial products that go wrong – the investor, the banks or the government? Whatever the outcome it could be a burden that impinges on growth in the real economy both in China and globally.
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