Investors must adjust their expectations for equities downwards but that is not to say there are no opportunities at all, writes UBS Wealth Management's Bill O'Neill.
All good things come to an end. After experiencing annualised returns of more than 15% during the past five years, it is time for investors to adjust their expectations for equities downwards.
Those who wish to stay stocked up on stocks must become accustomed to a level of return which is half that experienced in recent years. The new normal is, in fact, quite normal.
A stabilising economy and less volatility in the markets are the reasons for this. Recent returns in equities have not been driven by underlying economic growth but by unconventional monetary policy, which is now on a path to normalisation. The result? Annual equity returns are likely to be in the range of 7% to 8% over the next five to seven years.
However, equities are still appealing. In our view, the asset class continues to offer the requisite upside to justify a solid longer-term portfolio allocation, though we caution investors who may be spoiled by the gains of recent years to temper their expectations.
The following recommendations on constructing an equity portfolio in 2014 are likely to prevail for some time. It is critical, however, that the savvy investor is sufficiently agile to adjust speedily to changes in short-term market conditions to generate extra return.
US: A portfolio linchpin
Due to its favourable risk-return trade-off and its deleveraging lead, the US, in our view, still warrants a major share of any equity allocation. We expect the Fed to continue scaling back quantitative easing amid strengthening growth but continued low inflation.
This positive backdrop should enable US equity markets to endure the move to tighter money, despite the potential for higher bond yields to temporarily raise growth concerns. Such setbacks might create attractive entry points for investors who want (more) exposure to the US. In short, we expect the US market to return around 7% per year.
Eurozone and UK
Europe also deserves a significant position. Given its higher earnings yields, it has slightly greater potential than the US. The gradual eurozone economic recovery should translate into rising earnings and enable eurozone equities to outperform markets such as the UK and Switzerland, with their greater share of defensive sectors, such as healthcare and consumer staples. Nevertheless, monitoring the progress of the recovery is crucial, as ongoing economic malaise in weak countries could bring back euro exit fears.
The majority of equity returns in the UK will be driven by earnings growth. Earnings in 2013 were dragged down by the materials, healthcare and energy sectors, although we are unlikely to see such a dynamic in the coming year.
Healthcare is through the majority of its patent cliff and the outlook for China is more stable, which helps materials. Energy remains more of a risk but has already seen heavy revisions to earnings forecasts.
There is likely to be strong earnings growth across a broad range of UK sectors, led by financials and cyclicals. We believe next year’s UK earnings will be nearer to the current consensus forecast of an 8.3% increase than last year’s slightly negative earnings growth. It is this increase that will help push the UK equity market higher. Within the UK market, we continue to prefer more domestically and more cyclically exposed UK mid-caps.
Emerging market convergence
Economic convergence suggests the growth advantage emerging markets have enjoyed relative to the developed world will continue to decline in the coming decade. Moreover, emerging economies will converge towards developed ones in terms of the political and regulatory setting.
Investor concern about structural and liquidity issues that surfaced in 2013 will not vanish. Countries with current account deficits such as India, Indonesia and Turkey could face renewed currency pressure from capital outflows if Fed tapering is scaled up. China must liberalise its interest rates and open up its state-dominated service sector, while curtailing the risks associated with its five-year credit boom.
With exports expected to boost growth moderately, we expect emerging market company earnings to rise by about 10% in 2014, which should help broadly diversified emerging market equity indices to make gains.
The end of the credit bull run and the more moderated returns from equities merely represents a return to normality for investors.
A carefully-constructed portfolio of equities must form a part of the long-term investor’s plans. Just modify your expectations downwards and become accustomed to the new normal.
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