To start by looking back, 2013 was an incredible year for equity markets, despite the fact that the global economy failed to really kick back into life. This is a conundrum that can be explained by the unique nature of the ongoing economic recovery from the financial crisis of five years ago: it's been artificially driven to a certain extent, particularly by unprecedented monetary policy responses from some of the world's most powerful central banks.
2013: one hell of a year
Key US stock market index the S&P 500 closed the year out by reaching a new all-time high (see graph) on the final session of 2013, posting a staggering annual return of 29.6 per cent, making 2013 its best year since 1997.
This outrageous bullishness was not confined to the US markets. The German Dax index also rose to all-time highs with a 26 per cent annual return. But the index that destroyed these performance levels was the Japanese Nikkei 225, weighing in with a gargantuan annual return of 56.7 per cent thanks to the fiscal and monetary policy responses from Japan's new prime minister, Shinzo Abe.
These stellar equity performances came amid a backdrop of political turmoil in Washington, monetary policy uncertainty in the US, ongoing chronic unemployment problems in the eurozone, lacklustre corporate earnings growth, and well below average global economic growth rates.
Pumping it up
So how were these performances possible, you might ask? Well, when looking at the US stock market in particular, there are two significant forces responsible.
First, the Federal Reserve's monetary stimulus programme. The US central bank has been pumping $85 billion (£52 billion) of new money into the US economy every month for the whole of 2013.
This money floods into the banking system and drives down interest rates on loans, which in turn leads to consumers having lower interest payments on mortgages and other personal debts and therefore more disposable income to spend on the high street, spurring economic growth.
At least this is how things are meant to work in theory. In reality, the majority of this newly-created money is finding its way into assets like equities, as yield-hungry banks search for meaningful returns in this low-interest rate environment. So the Federal Reserve's newly-created money has played a significant role in pumping up equity prices.
Second, corporate America aggressively streamlined during the credit crunch and now that the economy is recovering, many of these companies have seen their revenues return back to pre-crisis levels. However, due to technology advancement and higher efficiency, companies have preferred to fulfill their larger order books with fewer members of staff. Therefore, the proportion of revenue spent on salaries in America is now at a 50-year low and it's the increased profitability resulting from this that's contributed to rising share prices.
So can the equity rally continue given that it's based on the above two factors? No. These factors are not sustainable on their own. In fact, the Federal Reserve announced on 18 December 2013 that they're going to begin winding down their stimulus programme, starting this month. So should investors be worried that the massive rally of 2013 is now going to be reversed? Here, in our view, the answer is also no.
The virtuous cycle
What might just happen in 2014 is that the above two factors are replaced by more natural and sustainable economic growth drivers. A virtuous cycle needs to kick in whereby larger corporate profits begin to feed down into wage growth for their workforces. The workforce then needs to take this extra income and spend more on the high street. More consumption means companies need to produce more products to meet this higher demand for goods. To do this they may need to increase their workforces by hiring more people. The result is that the unemployment rate falls, bringing more and more people back into the workforce where they'll be earning an income and are again able to consume. More consumption means increased revenue for companies and therefore larger profits, which then again feeds down into more wage growth, and so the cycle repeats.
We at Amplify Trading can see the early signs of this happening. Job creation has really picked up, both in the US and in the UK, in the last few months. Other economic measurements also look encouraging, with retail sales figures on the up, manufacturing output higher (see graph) and the housing market continuing to recover, and the net result of all of this is that GDP growth is beginning to surprise on the upside.
Despite the worrying reality that the Federal Reserve has begun to wind down its stimulus programme, the stock market has remained elevated as investors remain bullish due to "real" economic momentum building, rather than the artificially created momentum engineered by the central bank last year.
However, it's important to not get carried away. While I remain positive on prospects for the global economy in 2014, I don't expect equity markets to repeat the sensational returns of 2013. And of course there are always risks ahead.
As the economy continues to improve and the Federal Reserve reduces its stimulus programme by purchasing fewer government bonds, the returns offered on these bonds may rise because of an increase in supply. Rising government bond returns often mean higher interest rates in general. And if interest rates move higher in 2014, what will the impact on the economy be?
There are two factors to think about here. First, the corporate space: companies have been enjoying record low borrowing costs in the last few years, but how will these companies survive if these borrowing costs now begin to ratchet higher?
There are a lot of companies that in normal economic conditions would have failed a long time ago but have been kept alive by artificially low interest rates. These so called "zombie" companies may begin to hit some turbulence this year. But you could argue that, in the long run, the weak falling by the wayside is part of a healthy process of recycling that enables strong companies to consolidate their sectors and drive forward.
Rates moving higher can, of course, also negatively impact the consumer space. If mortgage rates begin to climb, homeowners may see their monthly interest payments increasing and therefore their disposable income sliding, and consumption suffering.
Deflation is another key risk for 2014, particularly in the eurozone. Inflation levels have dropped to below 1 per cent in Q4 2013, and if this downward trajectory continues then deflation becomes more and more likely. On the face of it, this might sound like a good thing from a consumers' point of view. But actually deflation sabotages consumption. Why buy now when I can wait and buy later when prices have dropped? Deflation can cripple an economy. Japan saw their economy consistently shrink in size for 15 years as a result of deflation. This is the economic nightmare that Shinzo Abe is trying to navigate out of with his aggressive stimulus programmes.
Another risk is that virtuous cycle described above doesn't happen. This may be the case if companies are reluctant to increase their staff wages. Wage growth has been virtually zero for years, and companies have become used to this new norm of high profit margins. However, chief executives need to recognise taking a short term hit by increasing salaries is actually the only real route to ultimately seeing their profitability improve in the long term through increased consumer demand. We need corporate America to take the leap of faith and boldly increase hiring, expenditure and salaries to fuel the virtuous cycle.
Also, there are always other potential risks that are very difficult to predict. Geopolitical tensions may flare up and present a military conflict risk. These kinds of risks can produce energy and commodity price spikes that can quickly derail economic growth. There's also political risk in Europe with economic reform fatigue, and in the US with their fiscal situation still remaining unresolved. Abe's Japanese recovery efforts may stall and the eurozone debt crisis still has the potential to come back to haunt us, with France's economic situation being particularly worrisome.
Having presented the risks, our Amplify Trading analysts and I believe that the positives will outweigh the negatives in 2014. We feel the virtuous cycle can gather momentum and as a result, stock markets should continue to climb, albeit at a slower pace than last year.
We expect the euro to weaken generally this year as short-term money market rates normalise and, as it will make European exports cheaper, this will be a positive for the region's economic recovery, which is significantly lagging behind that of the rest of the world. We anticipate commodity prices to drop, with the exception of gold, where we believe there is potential for a positive twelve months after the precious metal had its worst year in 40 years in 2013.
As traders, we expect to act on the views above during 2014. There will inevitably be a few bumps in the road in the months ahead, but these are part and parcel of the trading and the investment world. Onwards and upwards, and all the best for 2014!
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