When creating an investment strategy for 2014, it is important to differentiate between the structural framework and the short-term environment.

Structural framework

Weaker growth potential

Growth in most developed countries will be lower than it has been in the last several decades. The high levels of debt in private and public sectors and demographic trends are structural brakes on economic activity. More academically, to improve growth potential, there needs to be an increase in the number of people working and/or an increase in the productivity of the existing workforce. The first factor, expansion of the working population, is linked to demographic trends, social change (such as the proportion of women who work) and structural reforms (deregulation of certain sectors, attitudes to the welfare state). The second factor, an increase in productivity, relates particularly to such things as the quality of the education system and infrastructure and government advocacy for rights and innovation. At present, it is hard to be very optimistic about either of these factors.

Zero interest rates don't improve the economic situation

The experience of recent years shows that zero interest rate policies and quantitative easing have not improved the economic situation. This is inevitable: in a market economy, prices are very strong signals in the balance of supply and demand. The interest rate is the price of money. By manipulating this price and keeping it artificially low, the authorities create numerous imbalances, speculative bubbles and a mis-allocation of resources. In fact, rather than stimulating consumption, low interest rates actually penalise it since poor remuneration for savings means that people have to save more. Meanwhile, because companies know that the economic fundamentals are not good, they become reluctant to invest.

Dangerous monetary policies

The risk of significantly higher inflation longer term is increasing. In particular, the central banks of the developed countries seem to have abandoned their objective of price stability and most of them are now openly targeting higher inflation levels. Furthermore they are increasingly using monetary policy to stimulate growth or reduce unemployment, purposes for which these policies are not suited. The central banks have also succumbed to the dictates of the financial markets, their decisions often seeming to take account of the markets' interest rather than those of the real economy.

The long-term returns that can be expected from financial investments are very limited. For fixed-income investments, this is a direct consequence of low interest rates, and for stock market investments, the result of high valuations. Stock market history shows that the annualised return over 5 to 10 years obtained in the past by an investor buying into the US market at a similar valuation level as we are seeing today, is close to zero. The European market is not at such a high level of valuation but this is partly due to the composition of the index.

MSCI All Countries World Index in EUR

Source: Bloomberg

2014

The above points define the structural framework that an investor should never lose sight of but they do not necessarily define this year's environment.

The US economy could just spring an agreeable surprise in 2014, helped by lesser budgetary austerity, an upturn in private investment should the political climate improve, or the positive effects of the energy revolution. A temporary acceleration in US growth could have positive repercussions in other regions.

Similarly, the risk of inflation for the medium and long term is linked to the risk that, at a given moment, the monetary authorities will cease to be able to control the inflation they are currently trying to create. However, a return to inflation does not seem imminent in 2014 given that the deflationary trends inherent in an excess debt and low economic growth problem are currently still very much in evidence.

Lastly, the fact that the long-term annualised return of a stock market investment is low says nothing about the return in the short term. The valuation of shares is the key determinant in their long-term return but is not very useful for predicting their short-term results. For example, the following sequences all amount to an annualised return of 2% over 10 years (obviously these are not forecasts):

• + 10 %, + 10%, - 15 %, + 3 %, - 12%, + 6 %, - 40%, + 30 %, + 15 %, + 37 %
• - 20 %, + 10 %, - 5 %, + 12 % , + 5 %, + 7 %, + 7 %, - 10 %, + 15 %, + 5 %

or, to illustrate this idea more clearly:

• + 25 %, + 25 %, - 3 %, - 3 %, - 3 %, - 3 %, - 3 %, - 3 %, - 3 %, - 3 %
• - 25 %, - 25 %, + 10 %, + 10 %, + 10 %, + 10 %, + 10 %, + 10 %, + 10 %, + 10 %

Key factors 

Two parameters are likely to determine the performance of the financial markets in 2014: economic growth in the United States and the Federal Reserve's monetary policy. This does not mean that economic activity in other regions (primarily China) or the monetary policies of other central banks are not important. However, in practice it is the state of the US economy that determines the way investors assess the global economy and it is the Fed's monetary policy that conditions the policies of other central banks.

In this respect, the Fed's decision on 18 December removes an uncertainty and makes the second parameter clearer. The American central bank has decided to slightly reduce its asset purchase program to 75 billion dollars per month compared to 85 billion hitherto. At the same time, it has stressed the possibility of maintaining its key interest rate at 0%, even long after the unemployment rate drops below 6.5% (currently 6.9%). While it's always possible the bank could change its mind, the general thrust of this decision means that US monetary policy will remain expansive and, above all, that interest rates won't be going up in 2014. In theory, an environment marked by stronger growth, contained inflation and an expansive monetary policy should continue to be favourable to equity markets. Moreover, many companies continue to be reluctant to increase their capital investment, preferring to buy back their own shares or increase their dividend - factors that often boost their share price. In the same vein, we could see a renewed wave of mergers and acquisitions in 2014.

The investor dilemma

This puts investors in something of a quandary (assuming they share our analysis of the structural framework):

• the economic fundamentals are still precarious and the monetary policies currently being conducted will weaken them further in the long term;
• the equity market rises of the last 18 months are not justified by companies' earnings growth;
• the valuation of most stock markets offers little appeal and suggests disappointing results over the long term;

BUT:

• not being invested in equities in 2014 means accepting a low yield, or even a negative one after taking inflation into account (if limited to traditional financial investments).

The central banks' manipulation of interest rates thus encourages a rather perverse investment strategy, consisting of investing in equities for the short term, but not necessarily for the longer term whereas the essence of investing in equities should be with a long-term view.

Potential risks

In adopting such a strategy, it is therefore all the more important to be aware of the potential risks. I would tend to classify these risks in 3 categories:

• the possibility of a limited correction on the equity markets (0-10%):

after nearly 5 years of rising share prices, and especially after a very favourable year in 2013, this possibility could happen at any time, is not necessarily linked to a specific factor, and is therefore impossible to predict. It could just be triggered by the decision of a number of investors deciding to take profits. Such a correction could even be called healthy at a time when investor complacency is high;

• the possibility of a stronger correction on the equity markets (10-20%):

such a correction could be triggered by an unexpected change in the monetary policy of the central banks,long interest rates suddenly taking off despite near-zero short-term rates, a massive deterioration in the economic indicators of developed countries, or a 'snowball' effect from the financial markets of emerging countries (Turkey, Brazil and Thailand, for example) towards developed countries (similar to what happened in 1997/1998);

• the possibility of a collapse in share prices (20%-?):

such a collapse would most likely be due to an external event. A large part of the rise in valuations over the last 18 months has been due to the fading of certain 'tail risks' such as the systemic risk from the failure of a big financial institution or the risk of the euro collapsing. But have these risks really gone away completely? Most experts are still of the opinion that European banks are massively under-capitalised. As for the single currency, its present strength and the calm that seems to have reigned over the eurozone for over a year nowdo not mean that the structural problems have been solved. Certain countries will not be able to escape restructuring their debt; sooner of or later, France will lose investor confidence; Germany is increasingly worried about rising property prices, the result of an over-expansive monetary policy in relation to its economic situation; while the countries of Southern Europe are posting high levels of unemployment (especially among young people). It would be surprising if these factors did not trigger further tremors.

A further risk is that of the financial markets losing confidence in the monetary authorities. There could well come a moment when investors realise that "the emperor has no clothes", that the monetary policies currently being pursued are doing nothing to improve the economic situation and are dangerous over the long term. Low interest rates would then no longer be interpreted as a reason to invest in equities but as the reflection of a dangerous economic situation, similar to Japan's experience over the last twenty years. The decoupling of the real economy and the financial markets would cease. But the wake-up call could be very painful!

Obviously this list of risks is not exhaustive. As always, the best way for an investor to limit these risks is to buy good quality companies at a reasonable price. If there is a sharp market downturn these shares will suffer too, but their decline will only be temporary. The good news is that after a year in which it has often been lesser quality companies that have posted the biggest gains, there are still some good opportunities out there.

Guy Wagner, Managing Director

An economics graduate from the Université Libre de Bruxelles, Guy joined Banque de Luxembourg in 1986 where he was head of the Financial Analysis and Asset Management departments. He was appointed Managing Director of BLI – Banque de Luxembourg Investments in 2005.

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