What can investors expect in 2014?
New beginnings are exciting times and investors will be looking at the next 12 months with a mixture of anticipation and trepidation. Anticipation of better economic growth in the US and Europe, and the resultant improving outlook for corporate earnings, but there is also trepidation not least due to concerns on how bond markets will deal with the Federal Reserve’s planned unwinding of quantitative easing.
Bond yields to continue to rise
One theme that will continue in 2014 is the gradual rise in long-term interest rates, and the need to look at sources other than high-quality, long-term bonds for income. Speculation about when the Fed might begin to dial back its asset purchase programme came to an end in December and with a clearer path for the rate of reduction in purchases. At the time of writing 10-year Treasury yields were roughly 1 per cent higher than they were at the start of 2013, but remain very low by historical standards. But as the Fed tapers bond purchases and the US economy strengthens, the long end of the yield curve could continue to rise in 2014. The Fed will be very aware of the pace at which interest rates rise and will be keeping one eye on the housing market.
Rising interest rates suggest that investors may wish to remain underweight fixed income relative to long-term strategic allocations and focus on short-term maturities. Expanding their field of vision means investors can look to other areas of the credit market such as high yield, as the higher coupon should help offset capital losses due to rising interest rates.
US equity markets recorded stellar performance in 2013, but now questions are being raised on valuations and potential market bubbles. Earnings growth in the US should be modest and the outlook for economic growth has improved. Many of the tail risks, such as US fiscal turmoil, Middle East tensions and problems in the eurozone have started to fade – but not disappear.
The strong gains in 2013 do mean that US equities are no longer cheap in absolute terms though, so investors should temper their expectations and anticipate single-digit returns in the course of this year.
The pace of US economic growth should accelerate in 2014, with real gross domestic product growing by between 2.5 per cent and 3 per cent due to diminished fiscal drag from the sequester, still-high levels of pent-up demand for car, houses and business equipment, the lagged effect of higher wealth on consumer spending and the boost to exports from a stronger global economy. This stronger economic momentum should bring down the unemployment rate further and push the Fed towards phasing out bond purchases entirely in 2014.