As we ring in the New Year, we look back at another strong year for the U.S. equity markets. Most equity indices, as of Dec. 8, had posted very strong year-to-date gains.
The Dow Jones Industrial Average posted about a 7.6 percent increase, lagging both the S&P 500 and Nasdaq, which returned approximately 11.3 percent and 13.35 percent year-to-date, respectively. In addition, almost all of the European markets appreciated between 4 and 10 percent over the course of the year.
However, most European markets, after adjusting back to the U.S. dollar, returned a dismal -2 percent to -7 percent due to the significant strengthening of the U.S. dollar to the tune of almost 10.5 percent (which brings the dollar to a five-year high).
Regardless, this marks another consecutive good year for the equity markets and is making investors continually ask themselves whether the rise in stock prices will continue for a seventh year in a row.
To answer that question, it is best to examine the impetus for the prior increases in the stock market to see whether 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 the Fed’s stance on increasing the money supply by dropping short-term interest rates to record lows. Central banks have bought up trillions of dollars of government-related bonds, thus pushing investors from investments without risk 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. In the coming year, it appears interest rates may be increased, but they will still be at near historic lows, creating a very advantageous environment for the equity market.
In prior years, another reason for the equity market’s advance was due to the increase in profitability of corporations. Many corporations were not necessarily increasing their revenue as much as decreasing their expenses as a way of boosting their net income. Corporations were quick to trim their expenses by reducing head count, slowing down capital expenditures, slashing bonuses and returning their primary focus to their core business.
Overall, this made businesses much leaner and more profitable. In the current year, top line revenue has seen a very good increase and many corporations have been reporting record profits.
In prior years, companies with increased profitability have been nervous about adding workers or increasing long-term expansion by increasing capital expenditures except when absolutely necessary. Businesses seemed to feel very uncertain about the recovery, and with that they tended to redirect the money toward building up cash reserves and carrying out stock buy-backs. Stock buy-backs makes less stock available for investors to buy, thus putting upward pressure on stock prices as there is less supply.
In the current year, a considerable amount of money is going into businesses. This is partially reflected by the decrease in the unemployment rate from almost 7 percent last year to the most recent reading of 5.8 percent.
As we a head into 2015, it appears the market has a lot of momentum behind it. Most central banks will still maintain an easy money policy, and with low interest rates, investors will continue to be pushed toward riskier assets while providing individuals, as well as corporations, with cheap capital.
Unemployment has been slowly declining, which shows that small businesses have been forming and corporations have steadily increased hiring. In addition, the worries of previous years, such as the European debt crisis, have waned as countries such as Spain and Portugal have continued to cut budgets and to be given support.
We’ve even seen an uplift of Moody and S&P’s rating of Spain and Ireland, which one could infer as being very positive for the region. 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 which is the eventual increase in the short-term interest rates known as the Federal Funds Rate.
The expectation that the Fed could be moving to a tightening stance could create much volatility in both the equity and fixed income markets.
A two-pronged headwind to economic growth is the U.S. 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 its leverage, there is a need to cut the deficit, which will be done through austerity measures. This includes the cutting of 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 gains 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.
Reviewing Bloomberg consensus on the S&P 500, the median guidance of investment house analysts is the expectation that the market will still be positive more within the range of 7 percent to 9 percent during 2015. However, in the end, only time will tell if this will be the seventh year in a row of positive returns for the U.S. equity markets.
Disclaimer: The views expressed are the opinions of the writer and whil 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.