As we ring in the New Year, we look back at another extraordinary year for the equity market. Most equity indices, as of when the article was written on Dec. 12, had posted very strong gains year-to-date. The Dow Jones Industrial Average posted about a 20 percent increase, lagging in comparison to the Nasdaq, which was up approximately 33 percent year-to-date.
In addition, almost all of the European markets, taking into consideration the devaluation of the U.S. dollar, appreciated between 10 percent and 24 percent over the course of the year. This marks another consecutive good year for the equity markets and is making investors ask themselves whether the rise in stock prices will continue for a sixth year in a row.
To answer that question, it is best to examine the impetus for the prior year increases in the stock market and to see if that scenario may hold true in the coming year. Much of the stock market increases over the past several years are due to several factors. The factor that revolves around the central bank is their stance on increasing the money supply by dropping short-term interest rates to record lows.
By increasing the money supply, central banks have bought up billions of dollars of government-related bonds, thus pushing investors out of riskless investments and into riskier assets. In addition, by decreasing the short-term interest rates, they have decreased the incentive for individuals to save while simultaneously drastically decreasing the borrowing costs of individuals and corporations.
Another reason for the equity market’s advance is due to the increase in profitability of corporations. Many corporations have not necessarily increased their revenue as much as decreased their expenses as a way of increasing their net income. Corporations were quick to trim down their expenses by reducing head-count, slowing down capital expenditures, slashing bonuses and returning their primary focus to their core business. Overall, this has made businesses much leaner and more profitable.
Corporations flush with cash
With the increased profitability, many corporations have been flush with cash as the economy has begun to pick up steam. They have been nervous to add workers or increase long-term expansion by increasing capital expenditures except when absolutely necessary. With business managers feeling uncertain about the recovery, they have tended to redirect the money toward building up cash reserves and doing stock buy-backs. Stock buy-backs make less stock available for investors to buy, thus putting upward pressure on stock prices as there is less supply.
As we a head into 2014, it appears the market still has a lot of momentum behind it. Central banks will still maintain an easy money policy, and with low interest rates, investors will be pushed toward riskier assets while providing individuals, as well as corporations, with cheap capital. Unemployment has been slowly coming down, which shows that small businesses have been forming and corporations have been steadily increased hiring.
In addition, the worries of last year, such as the European debt crisis, have waned as countries such as Spain and Portugal have continued to be given support. Even Moody’s rating agency changed its outlook on Spain and Portugal to a “stable outlook,” by which one could infer there is much less risk of an epidemic crisis in Europe that will derail the global markets.
Although the environment looks strong for equities to have another good year, there are some headwinds that the global economy will have to face over the coming years. One of these is the eventual cutting of tapering and an increase in the short-term interest rates. This will lead to higher interest rates, and thus higher borrowing costs, for individuals and corporations, which is negative for the stock market.
Even the anticipation of rates increasing could cause longer-term rates to increase. This was seen on the 10-Year Treasury increase of rates between May and July, with yields from a low of 1.62 percent to around 2.6 percent, which resulted in a 30-year mortgage rate increase from approximately 3.7 percent to 4.7 percent.
Government debt looms
A two-pronged headwind to the economic recovery is the government debt. The economy has seen significant growth over the past decade due to lower tax rates. Tax rates will most likely increase in the U.S. as there is a strong need for the government to get its fiscal house in order by reducing the national debt.
The increase in tax rates will most likely slow the pace of growth of corporations and decrease a desire and ability of households to spend. Further, in order for the U.S. government, as well as other nations, to reduce their leverage, there is a need to reduce the deficit. This will be done through austerity measures, including cutting social assistance programs and infrastructure projects, which in turn may slow the pace of the global recovery.
As the stock market has increased, it has also stretched many valuation measures. Price-to- earnings ratios and price-to-book ratios have increased substantially with the increase in the stock market. All of these positive factors and negative headwinds have made many feel that there may be a ceiling on how much equity prices may increase over the year without another impetus to drive the equity market into double-digit returns.
Many investment houses, analysts and investors think this year has a limited upside of 10 percent, but feel that the odds are good for a positive year even with the six-year run-up in equity prices. But only time will tell.
Disclaimer: The views expressed are the opinions of the writer, and while believed reliable, may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.