Market View - January 2014

As we look forward to another New Year with our usual blend of a large measure of optimism together with a necessary degree of caution, let us first raise our glasses and toast the great stock ‘n’ roll party that was 2013!

We at Ash-Ridge Asset Management twelve months ago were quietly confident of a positive outcome from markets, and equities in particular when we wrote in last January’s market view “There is optimism that both Washington and Brussels will continue to succeed to kick their respective debt cans down the road, thereby avoiding market panics. If they are successful in this, and modest economic growth ensues, and 2013 does not experience any major black swan events, there is consensus optimism that even American equity sectors can advance again this year despite challenging historic valuations! So as we peer out over the dawn of 2013, we envisage another challenging year from an investment perspective albeit with attractive opportunities to hopefully not only preserve capital in real terms but also secure some additional appreciation for minimal risk.”

To be fair, we had not envisaged anything like the gains we have enjoyed over the past year on Wall Street, with the S&P 500 rising almost 30% (and recording no fewer than 45 new highs) during the year; the fifth best calendar year return for the index since its inception in 1957, with 1958, 1975, 1995 and 1997 the only years when investors did better. The US equity benchmark at the end of 2013 was up 173% since the post Lehman low of 676 in March 2009!

2013 turned out to be a record year globally as no fewer than 48 equity index records were recorded with most developed equity markets enjoying an excellent year in Wall Street’s slip stream, with the MSCI World and FTSE All World indices climbing more than 20% during the year. The Tokyo stock market (notwithstanding its enormous volatility) was the star performer as the Nikkei rose 57% (albeit the Yen’s decline of 22% versus the US $ took some of the gloss off these returns), while the FTSE 100 in the UK rose more than 14%, the German DAX climbed 26%, the French CAC almost 18%, and the European Eurofirst Index ended 16% higher for the year.

Ironically and somewhat disappointingly as we had hoped twelve months ago for a better outcome, emerging markets struggled as the threat of the Federal Reserve (Fed) in the US “tapering” its $85 Billion per month money printing programme otherwise known as Quantitative Easing (QE) sent foreign investors in both the equity and bond markets in many of these countries running for the exits resulting in the MSCI Emerging Markets index ending 2013 down around 9%. This was evident in May when Fed Chairman Bernanke first mentioned the tapering programme resulting in most Western equity markets faltering, but causing much bigger falls in Asian and other emerging markets, while many emerging market bond markets and currencies (such as the Indonesian rupiah and Indian rupee) also plunged!

Despite these worries, the BSE Sensex Index in India still managed to climb almost 10% (albeit foreign investors would have seen negative returns due to the devaluation of the rupee), while in China the Hang Seng rose 3.5%, but the Shanghai Composite was down around 7%. The emerging market economies of India, Brazil, Indonesia, South Africa and Turkey were identified as being most at risk from the Fed’s proposed tapering strategy due to their large current account deficits.

Away from equity markets, physical gold bullion suffered its first calendar year loss for twelve years and its worst twelve month return in more than three decades as it fell almost 30%. Fixed income markets offered mixed results with most government bonds such as US Treasuries and UK Gilts delivering negative returns as yields rose (to above 3% on the US 10 year benchmark), and some emerging market debt suffering badly due to the tapering uncertainties, but yields on many corporate bonds continued to fall and provide positive returns.

Overall market sentiment especially in Western developed markets remains encouragingly upbeat with increasing numbers of market commentators and money managers whom were staunch equity bears throughout 2013 such as Jeremy Grantham and Hugh Hendry turning bullish, and perhaps the consensus is best captured by comments in late December from BCA Research who said “We are still operating in an environment where monetary conditions are hyperstimulative and inflation is extremely low, and corporate profits will accelerate. This environment ferments asset bubbles, and underscores why there are high odds that equity prices will move into bubble territory next year”.

It is interesting that BCA Research refer to the likelihood of markets moving into bubble territory this year, as there has been widespread talk from many of the doomsayers of numerous markets including US equity, housing and government bonds having been in bubble territory for most of 2013. While valuation fundamentals in these markets admittedly look at the very least a little stretched, there are many counter arguments as to why talk of bubbles is as yet somewhat premature and why equity markets in particular could enjoy another year of good returns during 2014.

Naturally the economic background in the US (as well as some European countries like the UK) helps the equity argument, where the improving employment data, etc. contributed to the Fed in December at last commencing the tapering of its monthly QE programme (of purchasing US Treasuries and Mortgage Backed Securities) from $85 billion to $75 billion. Maybe more importantly though, one of the most important, and historically most reliable indicators, namely the US Treasury Yield Curve does not suggest the equity party is likely to end any time soon.

According to the National Bureau of Economic Research (NBER) in Cambridge, Massachusetts, each time the US yield curve has inverted since 1970, a recession has followed on average within twelve months. The yield curve normally slopes upwards from left to right, since the Western credit system dictates that interest rates at the short end (where most depositors sit) are normally lower than at the longer end (where most borrowers sit), but prior to financial crises or economic downturns, the curve will usually invert resulting in rates at the short end exceeding those at the long end, and therefore sloping downwards from left to right.

The yield curve inverted prior to the equity market setbacks in both 2000, and 2007, (which were followed by the respective recessions which began in 2001 and 2008) but reassuringly shows no sign of currently doing likewise. That is not to say that the situation could not deteriorate quickly were some of the economic or financial factors to change and as always we must carefully heed some of the potential dangers on the horizon, which include the continuing deleveraging threat from the shadow banking liabilities of Western banks and financial institutions as well as the increasing worries of similar problems in China and other emerging countries as Bank of England Governor Mark Carney reminded investors before Christmas “The greatest risk is the parallel banking sector in the big developing countries”.

Potential dark clouds on the investment horizon include Western demographic trends, as an increasing percentage of the population retires compared to those left in the labour force, which will continue to place a huge strain on both the financial and other resources of nations, with Japan a classic example where the number of those over the age of 65 has now reached more than 25% for the first time (by comparison it is currently 14% in the US). These trends will be partially offset in other countries through immigration (which is virtually non-existent in the land of the rising sun), although trying to ensure that ideally you don’t attract too many immigrants whom then overwhelm your benefits and support systems can be a tricky one, as the UK may be about to find out with the anticipated influx of Romanian and Bulgarian workers this year.

A major worry remains the huge combined total debt liabilities (personal, corporate, and government) relative to GDP of Western economies which are in most cases worse than they were prior to the Lehman collapse of 2008, with for example Japan now well over 350%, the UK at around 260%, the US at 250%, (nearer 350% if you include the debts of its financial sector), similarly Canada at around 250%, and Germany at around 220%. Most economic models suggest that once you exceed 150% of total debt to GDP, your economy will begin to struggle making progress against these burdensome headwinds!

Maybe the most worrying factor to keep us awake at night however is that investors have become almost totally reliant upon the Fed’s artificially stimulative QE, zero interest rate (ZIRP) and other policies to help stave off global deflation (with possibly an accompanying modern day depression), prop up a long in the tooth three decade old Treasury bull market (that may otherwise have long since collapsed) as well as propel equity markets ever higher. While investors on Wall Street, the City of London, and other global bourses have every right to toast Ben Bernanke and his fellow board of governors (who on the 23rd December celebrated the Fed’s centenary), for ensuring the past five years been rewarding for portfolios, both the short and longer term benefits for the majority on Main Street, and throughout the entire world remain highly debatable.

However to use a sporting analogy, “we can only play what is in front of us”, or maybe more appropriately from an investment perspective “we can only play the hand we are dealt”, and accordingly we believe 2014, while likely to be another challenging year, should offer us further opportunities to selectively grow portfolios, while as always keeping the control of risk at the heart of our strategies.

From all of us as Ash-Ridge Asset Management, we would like to wish you a Healthy, Happy, and Prosperous Year ahead.