We came into 2013 saying it was going to be a year of rational exuberance, and so it has proved.
The investment focus is now shifting to 2014. We expect markets to continue to view the political games being played in Washington as noise, and central bank policy action, by definition, as a fundamental signal. A fundamental signal should always trump noise, even when the noise is grating.
With the Federal Reserve on hold for a little longer, the Bank of Japan likely to increase stimulus again next year and the European Central Bank having just cut policy rates, equity markets should be well supported again in 2014.
Equity markets are not cheap, but they are not overextended either. They are running a little ahead of themselves, which markets sometimes do.
Why isn’t this year a replay of 1999? In a word: valuation. In 1999, the forward price/earning multiple on the S&P 500 was in excess of 24 times; currently, it is about 15 times. From a historical perspective, that is roughly fair value.
However, it is important to recognise that markets over and under shoot fair value targets thanks in large part to animal spirits. Where we are in the macro cycle and how policy makers and liquidity influence sentiment really matters. Animal spirits are still ambitious, but neither hubris nor complacency is yet driving investor behaviour.
Taper timing
The US recovery remains too close to stall speed for actual monetary policy tightening. But the Fed needs to prove that quantitative easing will not last forever by beginning to taper its $85bn-a-month bond-buying programme. The longer we go without tapering, the bumpier market turbulence will be once the Fed actually starts to taper as carry trades are again squeezed.
Bond markets never reprice in a smooth or straight line. They move in more abrupt steps as markets try to anticipate and push interest rates higher. Tapering may not be tightening, but it will press longer-dated interest rates higher. Expect to see more of that fixed income two-step dance in 2014.
The European Central Bank is moving in the opposite direction to the Fed. European and US interest rates are set to diverge further as US rates move higher, which should support the dollar. Europe is slowly pulling itself out of recession, while facing increasing disinflationary pressure, which is something to watch closely as it can negatively weigh on sentiment just as things begin to recover.
Looking ahead, while global growth remains anchored by emerging economies, it is developed market economies that are going to drive positive growth in 2014, as emerging markets continue to decelerate.
The big question for investors next year is: do international markets play a more meaningful game of catch-up to recent US equity market outperformance?
Playing catch-up
In Europe, economic growth is going from negative to positive, and earnings growth is doing the same, having been negative in the past few years. European markets are an operating leverage story for 2014, as profit margins gradually recover.
Japan remains driven by its currency market. A stable to weaker yen is good for earnings. A stronger yen is not only bad for earnings, but would signal that investors are questioning Abenomics – the programme introduced by Shinzo Abe, Japan’s prime minister, to pull the country out of deflation.
More policy easing probably lies ahead, but hiring and investment also need to rise, as do wages, to help sustain consumption. Ideally wage growth would come through salary increases rather than bonus payments, so expectations change and employees trust they will have money to spend.
China has been sensationalised this past year due to its new government and the fear of a hard landing. China is in transition and not close to a hard landing. The focus is on reform, in particular around lending, credit markets and the banking system.
From an equity market perspective, local stock picking and private equity remain the smartest ways to play the China transition and reform story. It is going to be a multiyear process, but ignore the detractors that continue to say China does not have a plan. It does: it wants to be the US without Washington.
The one certainty about next year’s outlook is that investing is going to get more complicated as return expectations need to be reset lower. 2014 is going to test the macro environment to see if the rest of the world wants to play catch-up to US outperformance. Investors need to watch whether budding investor exuberance remains rational. Valuations currently argue it will.
The extraordinary post financial crisis market recovery is not over yet.
Richard Madigan is chief investment officer at JPMorgan Private Bank
http://www.ft.com/cms/s/0/a0392ec4-5387-11e3-b425-00144feabdc0.html#ixzz2o95YAqQN
