Capital Economics has revealed where it believes the best opportunities and greatest risks lie for investors in equities and bonds in its outlook for 2014.
As the Fed gradually scales back quantitative easing, the consultancy’s chief market economist, John Higgins, expects the dollar to rise and government bond yields to continue to drift higher in tandem.
At the same time he expects investors’ appetite for risky assets to wane and is particularly concerned over the credit bubble bursting in emerging market equities.
While Higgins does not predict another very strong year for the US, he does not expect it to fall back sharply and expects the S&P 500 to end 2014 at around the 1,850 mark.
‘Two factors we expect to cap the upside for US equity prices are margins and valuations, which are both stretched by past standards,’ he explained. ‘However, this is partly the result of structural rather than cyclical forces, and we do not expect either to collapse.’
Higgins sees better value in UK equities, which he feels will also be aided by ‘minor’ depreciation of sterling against the dollar along with strong GDP growth. He tips the FTSE 100 to end the year at 6,900.
The developed market Higgins is most bullish on is Japan where he anticipates further yen weakness to help inflate the Nikkei to 17,000 by the end the year. ‘A depreciation of Japan’s currency had often tended to result in its stockmarket outperforming its US counterpart, with the relationship especially strong in recent years,’ Higgins said.
There is little optimism for emerging markets in Higgins forecast, although he does not believe the difference between performance in the region and the developed markets will be quite as wide this year. While he expects sluggish economic growth, falling oil and commodity prices and tapering all to have an impact, one of his biggest concerns is the emerging market credit bubble.
‘[There is also] the risk of credit bubbles bursting in some EM countries, such as Brazil, as well as the ever-present threat of political instability, as recent events in Turkey and Thailand attest,’ he warned.
Higgins expects things to be a little easier for treasuries in 2014.
‘The end of bond purchases under prior episodes of QE did not always entail a surge in their yields, as it dulled investors’ appetite for risk. We may see something similar with the phasing out of purchases under QE3,' he said.
‘What’s more, the FOMC’s strengthened forward-guidance suggests that expectations for short-term interest rates in coming years are likely to remain low. Indeed, if the committee is successful in anchoring short-term rates, there is little reason to expect long-term yields to rise sharply.’
Although Higgins believes the Fed will ‘tread very carefully’ and only begin to raise rates in 2015, he expects the anticipation of a tighter rate stance at a later date to cause 10-year treasuries to drift up to a 3.25% yield.
He does not expect gilts to be immune to events across the Atlantic but still sees some scope for UK government bonds to outperform treasuries and end the year at 3%. Higgins puts this down to the ‘wrongly’ expected view that UK interest rates will rise in 2015.
‘We no longer expect much of a lag between eventual first rate hikes by the Fed and the Bank of England,’ Higgins said.
‘However, the pace of subsequent monetary tightening may be slower in the UK than in the US, not least because the stance of fiscal policy in the former is likely to be considerably more restrictive.’
Meanwhile Higgins anticipates bunds drifting higher over the year, although with no rate rise on the horizon in Europe he expects yields to creep up to 2.25% by the end of 2014.
Elsewhere with yields on long-dated JGB’ decoupling from treasuries in reflection of the differing outlooks for Japan and the US, Higgins forecasts the yield on the 10-year JGB to close the year at 0.75%.
Finally Higgins believes prices of dollar-denominated emerging market government bonds are likely to come under some pressure ‘from further increases in both underlying US treasury yields and credit spreads,’ the latter of which reflects diminished appetite for risk.