Outlook 2014: Plowing Ahead?
"Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that"I like Ms. Kyrklund's Outlook 2014 which is why I began this post with her comment. I think she's right on the money with the main themes that will shape the next 12 months, especially Fed tapering and risks of deflation.
-- Lewis Carroll, Through the Looking Glass
Equities well supported
Like Lewis Carroll’s Red Queen, central banks in the US, Japan, the UK and Europe have often appeared to be getting nowhere in their attempts to generate economic recovery. However, in their determination to do whatever it takes to safeguard the financial system, fight deflation and bring down unemployment, they do now seem to be making some forward progress.
We expect their efforts will support continued economic recovery and maintain ample liquidity, meaning that the path of least resistance for equities remains up. While price-earnings multiples have already expanded significantly, we expect earnings growth should help to deliver high, single-digit returns from developed market equities in 2014.
Government bonds set to be buffeted
Just like this time last year, we expect the main source of volatility to come from government bonds. Forward guidance from both the Federal Reserve (Fed) and the Bank of England now explicitly takes account of unemployment targets when considering a rise in interest rates. As a result, even though the likelihood is that central banks will keep rates pinned to the floor, forward guidance could create confusion amongst investors as they respond to every twist and turn in employment figures.
To avoid getting whipsawed by data-driven noise, we remain underweight duration and are emphasizing credit exposures which carry less interest rate risk, namely high-yield debt, asset-backed securities and leveraged loans. Within equities, we have shifted from rate-sensitive defensive sectors towards more cyclical areas.
Emerging markets still carry risks
The outlook for emerging markets still generally looks cloudier than that for their developed counterparts. The absence of inflationary pressures is allowing developed market economies to run ultra-loose monetary policies. In contrast, some emerging economies face a deteriorating trade-off between growth and inflation which, when combined with current account deficits, may constrain central banks' ability to stimulate the economy.
Valuations across a range of emerging market assets have cheapened as prices, real exchange rates and yields have adjusted to the financial and economic challenges facing the region. Having avoided emerging market risk for a couple of years, the tempting valuations now on offer provide scope for tactical opportunities across a selective range of markets. Nonetheless, the structural impediments to emerging market growth make us more cautious on a strategic basis, so we continue to favour developed market risk for now.
Commodity prices could be tested in 2014
Our concerns about the emerging market macroeconomic picture also lead us to continue to avoid commodities. Since the last decade, commodity prices have been highly correlated with the growth in emerging market fixed asset investment and industrial production. High prices and expectations of continued rapid growth in emerging markets encouraged a significant increase in supply which, in our view, is likely to cause many prices to stagnate at best through 2014. Indeed, evidence of excess capacity in some parts of the emerging world poses a significant downside risk to prices.
Fed moves should support the dollar
We believe that the key driver of currency movements in 2014 will be the divergence in monetary policy among the major central banks. We expect the Fed to start the gradual process of ‘tapering’ its asset purchases in March, while the Bank of Japan will remain focused on curtailing the growing deflationary threat.
Consequently, we remain long of the dollar against the yen. Emerging market currencies are likely to suffer periodic corrections as the Fed begins to ‘normalize’ monetary policy by slowing the pace of quantitative easing. As a result, we will continue to avoid those currencies in countries with weak growth and twin current account and budget deficits, which we believe will be most vulnerable to Fed action.
Deflation remains the biggest risk
In terms of risks to our forecasts, our concerns remain more focused on deflation rather than inflation. Indeed inflation is very much the dog that hasn't barked so far. Measures of inflation continue to indicate a cool demand picture, which is mirrored by a lack of corporate spending. Ultimately we need to see economic confidence improve more meaningfully: central banks ‘running to keep in the same place’ is not a sufficiently solid underpinning for sustainable growth.
Below, I'll share my ideas on the outlook for various asset classes in 2014:
Equities will roar but pick your spots well: The macro backdrop still favors stocks over bonds but you better pick your spots well. In particular, the absence of inflation and tremendous liquidity from central banks will continue to support stocks and high beta cyclical stocks will continue to outperform as they did in 2013.
Having said this, the huge run-up in stocks indices over the last year won't be repeated so forget about passive investing. A few active managers who understand the macro environment will make huge returns in stocks but most will underperform once again. Importantly, despite the recent tapering, the risks of a melt-up in equities are much more pronounced in 2014 and we'll see parabolic moves in many high beta shares but not in the overall market. That means bubble anxiety will continue in 2014 but it will be concentrated in some sectors and stocks, not the overall indices (I like some biotechs, solars and tech stocks).
Once the mother of all liquidity rallies dissipates, we will have the mother of all liquidity hangovers, but we won't have to worry about that until 2015 or 2016.
Bonds are boring but not dead: I must admit, I'm a high beta junkie and love trading stocks that move. Bonds just don't do it for me, never did. In fact, I don't understand why anyone would invest in bonds given the historic low rates we're seeing. Nonetheless, I think the bond panic of 2013 was way overdone and given the risks of deflation, investors would be wise to invest in high quality bonds and carefully choose high dividend stocks of companies with low debt and strong cash flows (the backup in yields is presenting good opportunities on some interest rate sensitive sectors, like utilities and REITs).
Illiquid alternatives are frothy: In 2013, I warned investors about the bubble in private equity, infrastructure and real estate. I also explained why a lot of public pensions praying for an alternatives miracle are taking on too much illiquidity risk and are ill-prepared for a rough landing. Their approach is all wrong and they will get clobbered, especially if deflation sets in.
Having said this, the new religion in pensions is all about alternatives so expect shares of Apollo Global Management, LLC (APO), the Blackstone Group (BX), Kohlberg Kravis Roberts & Co. (KKR), and the Carlyle Group (CG) to continue trending up but nothing like the past couple of years (some of them invest in hedge funds which are more liquid than private equity).
The Return of Hedge Funds: According to Eurekahedge, the largest independent data provider in the world, last year was a record period of sorts for hedge funds globally. The data provider said assets under management by hedge funds worldwide expanded to an all-time high of $2.01 trillion, which is a $228.8 billion gain.
Most of you know my thoughts on hedge funds. There are too many beta bozos charging alpha fees (ie., 2 & 20), peddling their 'niche strategy', underperforming in up and down markets, and the industry has become a frigging joke. And unfortunately, in this environment dominated by useless investment consultants, emerging talent is having a hard time starting up.
But when it comes to alternatives, I prefer the liquidity of hedge funds and think top funds will continue delivering stellar returns, which is why I track their quarterly holdings carefully to gain insights on stocks to buy and short (if you do not know how to trade, don't bother with this information).
Commodities and emerging markets: In December 2012, I wrote a comment, A Lump of Coal for Christmas, recommending coal, copper and steel shares. In the last three months, I've noticed good activity in shares of Freeport-McMoRan Copper & Gold (FCX), United States Steel Corp. (X) and shares of Peabody Energy Corp. (BTU) seem to have stabilized (but still weak).
But I'm concerned about commodities and anything related to China and emerging markets. While some large asset managers are betting big on emerging markets, Fed tapering will potentially wreak havoc in these markets and their investment cycle is fully matured, meaning they don't need as many commodities to continue growing.
This is also one reason why I'm short Canada and other commodity-dominated indexes and currencies (like Australia). Stick a fork in these countries, they're done!
Gold won't shine again until ECB moves: In my last comment on hot stocks of 2013 and 2014, I discussed why gold shares (GLD) are way oversold and it's a good time to start accumulating at these levels. And as I stated in my comment from tapering to deflation, the ECB will have to crank up its quantitative easing, and when it does, gold shares will rally hard.
But be careful with gold. Just like other commodity shares, you'll see plenty of false breakouts due mostly to short covering. These counter-trend rallies are great to trade but don't be fooled, gold will not take off until the ECB starts cranking up its quantitative easing (short the euro, it's overvalued).
When will the ECB move? I don't know but I will tell you this, there will be another Greek haircut and it may come sooner than you think now that Greece has achieved a primary surplus by ramming through troika's insanely deflationary policies. Periphery Europe remains a huge concern for the global recovery and there is no doubt in my mind the ECB will have to crank up its quantitative easing. This is bearish for the euro but bullish for gold.
I hope you enjoyed this comment, I got to get back to doing what I love most, analyzing and trading stocks. Please remember to support this blog by contributing via the PayPal options on the top right-hand side and by clicking on the ads on this site. I thank all of you who send me kind emails but please show your support for the investment advice you receive for free or else I'll be forced to cut this blog to the few who do contribute (it's the fair thing to do).
Below, Bank of Tokyo Mitsubishi's Cliff Tan discusses the outlook for the global economy in 2014 with Rishaad Salamat and Angie Lau on Bloomberg Television's "Asia Edge,"stating inflation may be an economic risk (no chance, I'm more worried about deflation, especially if an emerging markets crisis hits us).
And Robert Morgan, chief investment strategist at Fulcrum Securities, offers his outlook for markets and rates in 2014 on Bloomberg Television’s “In The Loop.” I still like U.S. financials, small caps and technology shares and other stocks I discussed in my last comment.
Finally, Chaim Katzman, Chairman and Founder of Gazit Globe, discusses revenues from global properties and his worldwide economic outlook. He speaks on Bloomberg Television's “The Pulse.”