Getting to tomorrow

We started off the year with a scare from the emerging markets. The Argentine peso was devalued by more than 20 per cent, but other currencies in the developing world had declined sharply as well. Equities in these countries fell also, with many markets down 10 per cent or more.

In the developed world equities declined about 5 per cent, but in Japan it fell twice that.

At the beginning of the year I feared a sell-off and when people asked me why, I fumbled for a credible answer. My thinking was that sentiment was much too optimistic. Everyone had made money in the stock market in 2013, although few had done as well as the Standard & Poor’s 500. People were generally positive about the outlook for 2014 and there was a background of complacency. When these conditions prevail, something always comes along to shake confidence.

I continue to be constructive on equities and expect the economy in the United States to expand by more than the 1.9 per cent real growth rate reported for 2013. What worries me overall is the nature of the policy responses I see across the world.

(In Japan), the deflationary recession has ended and the economy is growing. dismantling regulation and producing sustainable growth — is proving harder to achieve.

Concern about growth

In the meantime, the aging population grows larger and the work force is reaching a peak. This could be countered by implementing a liberal immigration policy, but the country has no appetite for that. At some point the stimulative programmes will have to be scaled back and the question is: will the economy have developed enough natural momentum by that time to continue to grow? Concern about that may be the principal factor behind the recent sell-off.

In China, the Third Plenum in November outlined a plan by the new leaders, Xi and Li, to reduce corruption and rebalance the economy. Growth had been moving along at a 7% real rate but that was largely a result of the generous credit provided by the banking and shadow banking system. The agreement by many members of both parties (as well as the general public) that changes must be made. If we cannot get that done, remedial steps to sustain the long-term growth of the economy are unlikely to be taken. None of this is new, but these issues recede from investor consciousness as long as the economic and market performance are favourable.

The decline in the indexes in January has unsettled some investors who are students of market history. Since 1950 (according to Strategas Research), there have been 24 instances of a January decline. The full-year return in those years has been a negative 4 per cent with the median a negative 4.8 per cent, but the market had a positive return in 46 per cent of those instances, so I am not backing away from my favorable outlook for the year. As is often the case, the fundamental background deteriorated somewhat along with the market. Much of this was blamed on the bad weather. Retail sales declined by .4 per cent in January, the most in ten months. The weather discouraged shoppers from buying anything but cold weather gear. Auto and appliance sales were particularly hard hit. Weak consumer sales have caused some economists to revise their forecasts for first quarter real growth to 2 per cent or below. They may be right, but I still expect the economy to pick up later in the year, with the full year coming in at 3 per cent or above. Contributing to the view that the economy is softening was the sharp decline in the Institute of Supply Management (ISM) factory index for January, which dropped from 55 to 51, close to the level (50) which indicates the manufacturing sector is no longer expanding. I think weather may have had something to do with this also and believe we will see stronger data later in the year.

A study by Bianco Research shows that the correlation between the ISM factory index and GDP has declined sharply in this cycle. The ISM index for non-manufacturing was 54 in January, only a slight uptick, but services are much more important to overall growth.

China reports positive

Jobless claims are also higher, but vehicle production and industrial production data generally are favourable. Finally, the recent economic reports coming out of China are positive, which benefits all the countries that do business there.

Let’s hope that encourages the leadership to pursue the rebalancing programme and that they set an example for others. And since everyone is down on the emerging markets now, it may be time to take a hard look at some of them.

Also, Europe, surprisingly, had growth in the fourth quarter and I believe there are some opportunities there.

— Byron Wien is the vice chairman of Blackstone Advisory Partners LP