The year 2013 saw the 30-year bull market in bonds wind down and stocks soar, with a stronger recovery since 2009 than in the last five market cycles. As we move into 2014, strategists at Bank of America Merrill Lynch Global Research expect this trend to moderate but continue forward even with Federal Reserve tapering mid-year.
Ethan Harris, co-head of Global Economics Research at BofA Merrill Lynch, said: “After years of gloomy forecasts, we finally see a new year with no thunderclouds on the horizon. Growth is likely to pick up in most economies, but not enough to stoke higher inflation. While our baseline scenario doesn’t call for strong acceleration, all in all the outlook appears to be more balanced and better than it has been in years.”
Savita Subramanian, equity and quant strategist at BofA Merrill Lynch, is being more bullish than most. “Markets have settled into what has generally been a sweet spot for equities: low but rising rates, low inflation and a pickup in economic growth,” she said in a note. “We believe we are on the road to normalcy and that U.S. equity markets should continue to climb higher.”
Here are the 10 macro calls for the year ahead by the BofA Merrill Lynch Global Research team:
The S&P 500 (INDEXSP:.INX) Index is expected to rise to 2000 and the MSCI All-Country World Index to reach 444 by year-end. Gains in the year ahead imply a price return of approximately 11 percent, with modest earnings growth of 7 percent, driven by higher sales and additional buybacks. Sectors BofA favors are technology, industrials and energy. The industrial sector has the highest percentage of high-quality stocks, and energy is the most under-owned it’s been, relative to its weighting, since 2008. Sectors with challenges include consumer discretionary, utilities and telecommunications companies. Consumer discretionary companies, in particular, could be hurt by rising rates.
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U.S. and global economic gross domestic product growth is expected to accelerate in 2014, to 2.6 percent and 3.5 percent, respectively. The U.S. economy is expected to expand in the second half of the year at a 3 percent rate, driven by the end of fiscal austerity and pent-up demand for capital goods. Slow growth of 0.8 percent is expected in Europe as credit and fiscal policy remains tight. China’s GDP growth will marginally decline from 7.7 percent in 2013 to 7.6 percent in 2014, but remains highest among the leading emerging market economies, while Japan is in transition, with another year of 2 percent growth.
Modest rebound for emerging markets. Following flatlined growth since 2007, the emerging markets should prove resilient in 2014, with modest growth recovery and rising productivity. Emerging market GDP is expected to rise 4.9 percent in 2014 with modest returns of 2.9 percent, 0.7 percent and 0.3 percent for local debt, emerging market foreign exchange and external sovereign debt. In 2014, BofA suggests that investors should focus on markets that have worked hard on reforms for sustainable growth rather than surfing the waves of commodities and credit. These markets include China, Korea, Mexico and Poland. They are also bullish on Russian equities and favor Turkey despite near-term headwinds. The firm’s top bond and currency picks: longer-duration bonds in Colombia and Russia and external debt in Hungary, South Africa and Venezuela. Among currencies, BofA likes the Mexican peso and Hungarian forint against the euro and the Korean won against Japan’s yen.
U.S. rates to head higher, with 10-year Treasury yields expected to reach 3.75 percent. A rise in the Treasury yields by 85 basis points will have consequences for markets around the world, likely resulting in an increased interest rate differential in favor of the U.S. dollar, especially against the euro, which is expected to decline to 1.25 by year-end. In addition, rising rate volatility may surprise. Interest rate volatility is expected going into 2014, with a target of 100 for the Merrill Option Volatility Expectations Index (MOVE). Market complacency over the timing and impact of Fed tapering could leave some investors unprepared for rising volatility in rates. Long volatility positions in U.S. rates and dollar and long swap spread positions are favored as insurance against higher interest rate volatility.
Challenging year for fixed income. Tightening spreads and rising rates could make total returns challenging for fixed income investors. Corporates are favored over government bonds. High-yield bonds are expected to produce positive returns, though about half the gains seen in 2013. U.S. high-yield bonds may offer the best potential, with a total return of 4 percent to 5 percent. Among investment-grade bonds, Europe should lead the way with a return of up to 2 percent, followed by the U.S. at 1.5 percent, while Asia and emerging markets may suffer negative returns.
Global inflation rate to remain stable at close to 3 percent. After surging in 2011, inflation has fallen in almost every country, with the exception of those facing foreign exchange fueled price increases, namely Japan, Brazil, India and Turkey. Inflation in emerging markets is expected to increase from 4.7 percent in 2013 to 5.3 percent in 2014.
The U.S. housing recovery continues. The ongoing strengthening of the U.S. economy is expected to boost real estate values by another 5 percent in 2014.
Oversupply to contain commodities pricing. Global commodities prices will be contained in 2014 by oversupply in key sectors, especially global oil and grain, a strong U.S. dollar and modest global economic growth. The Merrill Lynch Commodity Index (MLCX) is expected to decline by 1.6 percent, less than the steep 5 percent decline in 2013. Gold values are expected to drop to $1,250 an ounce in the first quarter, before rebounding to normal levels later in the year. Other metals not in surplus, including zinc, platinum and industrial metals, could outperform.
“Three Bs” corroborate evidence of great rotation. Higher bond yields, a higher “buck” and higher bank stocks (a leading barometer of domestic demand) in 2014 will corroborate evidence of a great rotational shift in the markets: outperformance of real estate over commodities, stocks over bonds, developed markets over emerging markets, small cap over large cap, high yield over investment grade and cyclical over defensives. The shift will continue in 2014, with Fed tapering causing little, if any, pause in the process.
Institutional reverse rotation. While the attractiveness of equities lures retail investors away from bonds, institutional investors, including insurers, sovereign wealth funds, central banks and even U.S. pension funds, are expected to take part in a “reverse rotation” -- selling stocks and buying bonds.
(Note: Photo by Shutterstock.com.)