Predicting the 2014 markets

Alistair Wilson gives an overview of last year’s major market events and provides his investment outlook for the year ahead

It’s that time of year again when we stick our necks out and attempt to predict how markets will perform over the coming 12 months.

So starting with 2013. As it turned out, it was generally another strong year for risk assets, with continued improvement in the eurozone where the recession finally ended in the third quarter. It was also a year for continued intervention from the authorities, with Japan stealing the limelight and fuelling a strong risk rally in the world’s third largest economy. On the other side of the globe, the US recovery continued despite the strong fiscal drag, prompting perhaps the most significant event of the year, which was Bernanke putting the world on notice that the Fed was looking to taper its $85 billion a month purchases, although this ‘message’ was somewhat diluted in subsequent addresses. As a consequence, equity markets enjoyed a relatively strong year, with markets in Europe’s periphery and also Japan showing particular outperformance.

In fixed income, the risk rally, combined with tapering talk, has led to a divergence in performance, with ‘risk off’ rates markets generally showing a negative performance on the year, e.g. the gilts index year-to-date being down 3.1 per cent. On the flip-side, ‘risk-on’ fixed income continued to perform strongly as credit spreads continued to grind tighter, under what can only be described as near ‘optimal conditions’ with ultra-low defaults, low base rates, an improving economic backdrop and ample liquidity.

As we enter 2014, we do so with a better macro-economic backdrop, but with the authorities still heavily supporting markets. This is not too dissimilar to this time last year, although the support may well reduce in 2014, as the economic recovery advances. Our top-down thesis is that credit should outperform and rates will be vulnerable to both Fed tapering and any hint of inflation. Our strategy for outperformance in fixed income would be to continue to invest in selected credit opportunities but on an interest rate hedged basis.

Our top sector pick is a close call between European mezzanine ABS and subordinated financials, with the former remaining the cheapest asset class on a historic basis. In the financial sector, most jurisdictions have now approved the definition of what qualifies as Basel III compliant Additional Tier 1 (AT1) and Tier 2; as such we are expecting a raft of new issuance in this sector, and we expect it to be issued cheaply while the markets become familiar with the structures. On a rates hedged basis, we think these are the only sectors that have the chance to produce double digit returns in 2014.

At the macro level we think that the Fed commencing tapering has the potential to cause volatility in 2014, not just in rates, but also in stocks, credit and particularly emerging markets, if the tapering is too sharp. The eurozone, which has been at the heart of most surprises in recent years is a lot less likely to produce one in 2014, with a Greek recovery potentially a major surprise. We expect Portugal to successfully exit their programme in 2014, but we were divided as to whether they would take an OMT or not. We see taking an OMT as being positive for the eurozone, as this tool, which has been so effective, remains undrawn or untested.

Onto base rates, almost unanimously we see these as remaining unchanged throughout the year, with one of our team calling for the ECB to trim the refinancing rate at the same time as a move to a slight negative deposit rate. All of these features should be supportive for the default rate in Europe, which we expect to close 2014 not far from today’s rate, at around 2 per cent.

Finally and on a worrying note, we were quite close on our forecasts for equity markets. The range of projections for the FTSE was between 6,900 and 7,200 for this time next year. That one we can almost guarantee to be wrong.

Alistair Wilson is head of institutional business at TwentyFour Asset Management

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