Column: Five predictions for financial markets in 2014

Written by Reuters | Updated: Jan 4 2014, 10:49am hrs
Happy New Year! For the first time since 2008, we investors, economists and businesspeople say these words without irony. While last year was statistically disappointing, with global growth slowing slightly from 2012, the verdict of financial markets and business sentiment has been much more consistent with my predictions. Despite the apparent slowdown, stock markets enjoyed their best performance since the 1990s, long-term interest rates soared and consumer confidence all over the world ended 2013 much higher than it started. This apparent paradox is easily explained: the statistical weakness of 2013 was due entirely to a very weak period last winter, connected with the US presidential election and leadership transition in China. By the second quarter, growth had revived in the US and China and accelerated strongly in Britain and Japan.

That conventional wisdom last January was far too pessimistic about the economic outlook is evidenced by the subsequent behaviour of financial markets, where equities outperformed bonds by the biggest annual margin on record. But today almost everyone is optimistic. So what unexpected developments could surprise financial markets and business sentiment in 2014 Below are five personal guesses:

Four is the new two

The US economy will grow by about 4%, much faster than the 2.5% to 3% predicted by the IMF and mainstream economic forecasts. In the last reported quarter, the US economy was already growing by 4.1% and the private sector by 4.9%. If the US accelerates to around 4%, so will global growth, and 4% will replace 2% as the growth rate assumed in business and financial planning. Global inflation expectations will rise to around 3%, raising the benchmark for global growth in nominal terms to 7%, similar to the 10 years before the 2008 financial crisis. In other words, the new normal of global stagnation widely predicted after the crisis will turn out to be not very different from the old normal.

Still a long way to go for 2013 trends

While the gains of over 20% in major stock markets may not be repeated this year, equity prices in most of the world should continue risingand bond prices continue falling. Wall Street has now decisively broken a 13-year trading range and past experience strongly suggests that this breakout signals the start of a bull market in global equities that will last for many years. Shifting from history to financial fundamentals, the 6% or 7% nominal growth I expect in the global economy should translate into similar growth in corporate revenues and earnings. That would imply similar gains in equity prices, even without any increase in price-earnings multiples or leveraging up of corporate balance sheets through stock buybacks. Given that equity valuations are still only slightly above long-term average levels and that companies are flush with cash, there should be scope for considerably stronger gains in many stock markets.

The biggest problem for stock markets will be higher interest rates, since 10-year yields will rise to at least 3.5% as the US economy accelerates. But history shows that stock market prices usually rise alongside rising bond yields during periods of economic recovery, provided short-term rates remain low. And luckily for equity investors, the Fed will maintain its commitment to zero short-term interest rates however much the economy accelerates, because Fed officials see rapid growth as a natural and welcome development after five years of deep recession.

European crisis will metastasise

European central bankers see rapid growth as a portent of inflation and will start hinting at tighter money as soon as economic conditions improve. The conflict between strong growth and easy money has already appeared in Britain. It will become a major political problem in 2014, because the improvement in economic activity depends entirely on a property boom that the Bank of England is trying (unsuccessfully) to deflate. As a result, the sterling will continue to strengthen, central bank independence will come under pressure and the British economy will become ever more unbalanced, generating the worlds biggest trade deficit relative to GDP.

In the eurozone, by contrast, economic conditions will remain feeble at least until the summer, when a shift towards more expansionary monetary and fiscal policies will be triggered by panic in Germany about the big victories for fringe nationalist and neo-fascist parties in Mays European elections. As a result, the euro will weaken and the southern European economies will finally start to recover, but not until the second half of the year.

Japan will shoot itself in the footagain

Japan is the major economy most likely to disappoint expectations in 2014. The consumption tax increase in April will produce a fiscal tightening worth roughly 2% of GDP, after allowing for some feeble offsetting measures. As a result, Japan will probably sink back into recession by the second quarter and the stock market will fall sharply, even though the Bank of Japan will try to ramp up its monetary stimulus and the yen will probably weaken further.

EMEs will make a comeback

With the US accelerating to 4% and China growing steadily in the 7% to 8% range, emerging markets will come into their own as investors realise that most of these economies have more to gain from robust economic conditions and stronger commodity prices than they have to lose from slightly higher interest rates. There will be exceptions. Financial problems may intensify in countries with large trade deficits or political mismanagement, such as Turkey and Brazil. On the other hand, two major economies now treated as pariahs could do surprisingly well. In Russia, the recent release of Mikhail Khodorkovsky could signal a newfound respect for private property rights. And a nuclear deal with Iran could bring this potentially dynamic economy back into the civilised world, as well as transforming Middle East geopolitics. But at this point, I am probably getting too optimistic even for a New Year pipe dream.

Anatole Kaletsky