The worst of Europe’s troubles appear to be behind us. We do not expect a return to the depths of the sovereign crisis of 2010 to 2012 but we do believe that equity markets have priced in a stronger recovery for Europe than will actually transpire.
The eurozone appears set for a period of low growth and very low inflation; so low in fact that the ECB may be forced to act to stave off deflation, which we are already seeing in some peripheral economies.
Our concern is that a GDP growth level of around or below 1 per cent will not be enough to drive company earnings higher to justify the rebound in share prices. With emerging market growth levels slowing, exports cannot be relied upon to support European firms but a potentially weaker euro could be supportive.
Meanwhile, credit expansion in Europe remains constrained by banks’ continued focus on repairing their own balance sheets. Economic growth will not be sufficient to make significant inroads into the elevated unemployment and youth unemployment levels in some countries.
It will be interesting to see the levels of frustration with incumbent governments at the European elections in May; a strong showing for some of the more extreme or anti-euro parties will serve as a reminder that all is not fixed within the eurozone.
Emerging Markets have had a turbulent start to 2014 after struggling to make ground in 2013. While emerging market equities are undeniably cheap, we expect that sentiment will remain cautious on the asset class. In some cases, fundamentals are reasonable but history tells us that sentiment can swing negatively quickly and when this happens investors do not discriminate in their rush for the exit.
Provided China does not deliver any negative growth shocks and the impact of QE tapering on fund flows does not become too dramatic, those emerging markets with reasonable fundamentals and credible central banks could start to perform.
Country selection will be very important though given that the fundamentals of some countries look considerably stronger than others and for now we believe the risk-reward is more attractive in other regions.
Last year saw decent growth in the US and it should be even stronger in 2014 due to the significantly lower levels of fiscal drag which held back growth last year. However growth may be skewed towards the second half of 2014.
Given the higher levels of political visibility and a supportive economic backdrop, we should see capital expenditure pick up and are likely to see more companies spending grow, which means M&A should accelerate.
Meanwhile, the consumer should continue be supported by the housing recovery and an improving employment backdrop, with the potential for wages to pick up as skills shortages begin to emerge in sectors such as construction.
The US market is not cheap but it is not expensive either. But with the S&P 500 index already at record highs, we will need to see the pick-up in economic growth leading to higher earnings which in turn will support higher equity prices; that is entirely possible this year.