Capital spending should recover in 2014 – Schroders

Simon Webber, lead portfolio manager, Global and International Equities and Bob Jolly, head of Global Macro, give their outlooks for global equities and fixed income markets going in to 2014.

Simon Webber gives his views on expectations for global equities markets:

• As corporate confidence gradually improves, capital spending should recover, benefitting capital goods and investment-related sectors.

• Low rates and the search for yield have left companies with high expected future dividend and earnings growth looking extremely cheap relative to high yield equities.

• Markets anticipate and will price in future interest rate rises, benefitting companies that can thrive in such an environment.
2014 has scope to be another good year for global equities. What’s more, as the dominance of macroeconomic factors on equities recedes, market leadership should begin to transition towards companies able to thrive in a more normal economic and monetary policy environment.

Economic backdrop
Having retreated since 2010, global growth in 2014 should accelerate with full year global GDP growth likely to be in the region of 2.9%. We expect this improvement to be driven by Western economies, with Europe and the US both growing faster than in 2013.

A year for stock pickers
We are confident next year will be good for stock pickers. Since the 2008 market crash, financial markets have been buffeted by macroeconomic events, be it the 2008 financial crisis, the eurozone sovereign debt crisis or unprecedented money printing by central banks. However, as the growth and policy environment begins to normalise, markets will naturally lengthen their investment horizon and should therefore increasingly focus on companies’ long-term growth prospects.

Markets have already been less impacted by macroeconomic events in recent months. This is in part because of a real and perceived reduction in structural risk, but also because there is a growing resilience and breadth to the economic recovery – note the far more muted market response to the US budget and debt ceiling crisis in 2013 compared to 2011.

Confidence to invest
Despite the improvement in economic conditions this year, consumer and corporate confidence has been slow to adjust. Companies have been reluctant to invest, meaning that fixed capital formation – a measure of investment – remains below average in both the US and the eurozone.

This is despite the fact that large company balance sheets are generally still very healthy (because of the still largely cautious corporate mind-set).
However, we are now seeing signs that confidence is returning. We therefore expect that as confidence continues to recover next year, companies will step up investment. This will be particularly good for industrial cyclicals and capital goods industries. It will also give further momentum to the economic recovery.

Positioning for higher rates
After years of loose monetary policy across the globe, markets in 2014 will have to wrestle with the timing and implications of interest rate rises. The vast amounts of money being pumped into the global economy via quantitative easing programmes have given many indebted companies an easy ride, and among other things, propped up real estate markets around the world.

Furthermore, depressed bond yields have forced income-focused investors to search for income in higher-yielding parts of the equity market. This has pushed up the valuation of higher-yielding stocks as investors have searched for bond-like returns from stocks with minimal equity risk. This has left companies with prospects for strong future earnings and dividend growth looking exceptionally good value relative to income stocks.

The low interest rate environment has therefore distorted equity markets in recent years. For patient stock pickers, this opens up opportunities for future outperformance: next year, investors should look for companies that can thrive in a rate-normalising environment. This will have impacts across almost all sectors; for example, banks with very strong deposit franchises and life insurance companies which will earn better returns on their investment portfolios. Individual companies with strong brand and pricing power should also perform well in this environment, as should later-cycle cyclical sectors like capital goods.

Global competitiveness is shifting
One country which will likely buck the trend of a rising rate environment is Japan. Japan’s government under Shinzo Abe is positively encouraging a more inflationary environment and if the current policies are not successful, its central bank will likely step up its quantitative easing efforts further. Current monetary policy should continue to be good for Japanese exporting companies after many years of a strong currency headwind. However, any further weakness in the Japanese yen will also further affect the competitiveness of companies competing on a global stage. In particular, German, Korean and Taiwanese exporters are likely to feel some pressure, and this is something we are monitoring carefully across our investment portfolios.

When the tide goes out
Ultimately, throughout 2014, we will be moving to the next phase of the economic cycle. Momentum in early cyclical stocks will inevitably move to later-cycle areas of the market. Complacency in the market about the low interest rate environment will open up opportunities for astute investors. To paraphrase Warren Buffet, when the tide goes out, we will see which companies, and perhaps which investors, have been skinny dipping.

Bob Jolly gives his outlook for global fixed income markets:
• The eurozone still faces myriad problems, of which the threat of deflation is probably the most worrying.
• On balance, developed market central banks would rather be too late in tightening monetary policy than too early.
• Bond investors will need to remain nimble in 2014 – this is not a market in which your long-term strategic views are going to make you money every month.

In last year’s investment outlook we discussed how the world’s economies face a long and winding road to recovery. One year on, and some countries find themselves further down the road than others. Those nations who responded most aggressively to the crisis that began five years ago are beginning to see positive results, while those who were more ponderous still face massive challenges.

The European Central Bank is fretting about deflation and is mulling both quantitative easing (QE) and negative interest rates, while – in contrast – the Bank of England (BoE) has already cast QE to the history books and it appears it won’t be long until the US Federal Reserve begins to end its greatest ever experiment, ‘QE infinity’.

US out in front
The US is furthest along the road, having thrown everything but the kitchen sink at its problems; recapitalising its banking system, slashing interest rates and embarking on QE on an enormous scale.
The one missing ingredient in the US currently is the consumer confidence that Americans normally have in abundance. With the housing market recovering and the stockmarket near record highs, confidence should pickup in 2014.

UK accelerating
Meanwhile the UK is slightly behind the US, although it has seen significant improvements in recent months. It appears to us like a pre-election economic acceleration, caused by government schemes such as ‘Funding for Lending’ and ‘Help to Buy’. These are creative ways the government has used to avoid actually spending money, creating an off-balance sheet liability rather than doing what it should probably really do: build houses. But the UK is also being boosted by small improvements in its main export market – Europe – and by a pickup in lending.

Longer-term impediments
Despite improvements and grounds for optimism in the UK and the US, there are a number of structural headwinds and uncertainties that may impede a longer-term upswing.

There remain considerable balance sheet issues that need to be dealt with, on both a government and household level. The US, for example, has never outspent its revenue (outside of wartime) by such a degree as it has in the past five years. The UK, meanwhile, tried to address its balance sheet issues by cutting back on spending and imposing austerity – but the result was a significant loss of revenue.

Furthermore, households also have a long way to go to repair their balance sheets. Having overspent and lived beyond their means for years, the structural adjustment needed won’t take weeks or months. Mortgages, for instance, take decades to pay off.

Europe the laggard
Europe appears to be at least 18 months behind the US on the road to recovery and it is currently stalling. Eurozone unemployment is around 12% and is likely to go up rather than down. One of the reasons growth is not accelerating is that banks are unwilling to lend to companies as they fear the risk of defaults and blowing even bigger holes in their balance sheets.
We think there is a strong probability that we see QE from the ECB. The region still faces myriad problems, of which the threat of deflation is probably the most worrying.

The spread of disinflation and deflation is getting broader. When you see headline inflation coming down, often it is just due to the oil price, but when you see disinflation in everything you buy, from food to cars to TVs and household appliances, that is when a central bank’s nerves really start jangling. Such a scenario reflects a genuine lack of demand causing corporates to reduce their profit margins to stimulate demand. Europe is much closer to this than it was a year ago. In addition, the output gap or spare capacity of the eurozone’s economy (the difference between actual GDP and potential GDP) could grow and add to disinflationary pressure.

Investment implications
Disinflation aggravates debt dynamics by making repayments increasingly hard to meet. One of the only ways the ECB can deal with this is to weaken its currency. This is why we favour short exposure to the euro versus a variety of currencies.

The Fed’s decision to delay tapering in September reinforced our view that developed market central banks would on balance rather be too late in tightening monetary policy than too early. Central banks remain acutely aware of the danger of derailing a nascent recovery by tightening too soon; preferring instead to keep policy accommodative for longer and risking a potential inflation problem in later years. The implication of this is that we expect policy rates to remain low until at least 2015.

In Europe we will take opportunities to buy short-dated bonds whenever they selloff. Short-term rates will ultimately be anchored by low base rates and the larger shifts will happen further along the yield curve.
Bond investors will need to remain nimble in 2014, this is not a market in which your long-term strategic views are going to make you money every month, so you need to trade around your core views and take advantage when uncertainty causes mispriced opportunities.

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