The year 2012 was good for the market, but I expected the United States economy to experience slow growth in 2013 and I was worried that corporate revenues would only increase modestly. As a result, I thought profit margins ran the risk of peaking and earnings could be disappointing.
As it turned out, the economy did only expand slowly throughout the year, profit margins were essentially flat and revenues were not robust. Share repurchases were strong, however, as companies used the considerable cash on their balance sheets to reduce the number of outstanding shares, and therefore increases in earnings per share were pretty much on target. Corporate net income for the year was less impressive.
The Federal Reserve remained accommodative throughout the year, increasing its balance sheet by over $1 trillion (Dh3.7 trillion) through aggressive buying of Treasurys and mortgage-backed securities. A large part of this liquidity found its way into financial assets, keeping interest rates low and causing equity prices to rise.
By the end of the year, the US economy was doing better. The European Union remained intact and the euro looked like it would endure as the continent’s currency, but few structural reforms (like a banking union) had taken place.
In the United States, some fundamental reasons for optimism were also developing. The definition of a surprise is a market-influencing event where I believe the probability of it happening during the year is better than 50 per cent, but most money managers would only assign a one in three likelihood of it taking place.
In my first Surprise, I thought the S&P 500 might suffer a correction of as much as 10 per cent early in the year because investor attitudes were too optimistic and the market almost always experiences a setback when the various sentiment measures (particularly those based on transactions) are so positive. I thought that geopolitical problems in Iraq, Iran, the South China Sea, or Afghanistan would contribute to investor nervousness. I believed the S&P 500 would be up 20 per cent for the full year, however.
In the second Surprise, I thought that the economic momentum that was building in the latter part of 2013 would continue and that the US economy would show growth in excess of 3 per cent. I also said that the unemployment rate would drop to 6 per cent by year-end. I had no idea that it would decline 0.3 per cent in December, but that was primarily because the participation rate dropped.
I expected the Federal Reserve to continue to reduce its monthly bond-buying programme without having a negative impact on either the economy or the stock market. Last spring, when then–Fed Chairman Ben Bernanke suggested he might taper, both the bond and stock markets reacted sharply, but in December when the first wave of tapering was actually announced, stocks continued to rise.
That’s because, by then, investors knew a reduction in bond-buying was coming but the economy itself was doing better. As long as that is the case, further reductions in the Fed’s accommodation should be absorbed by the financial markets without a dislocation.
In the third Surprise, I expected the dollar to strengthen. Currencies often reflect the differential growth rates of various economies and United States will be growing much faster than Europe or Japan. But currencies are also affected by monetary policy and the Federal Reserve balance sheet has been increasing while that of the European Central Bank (ECB) has been decreasing as loans made to banks on the continent have been paid back. That partially explains why the euro has been relatively strong recently. Now the Fed is reducing its bond-buying and the ECB may become more accommodative to bolster growth there. I think we could see dollar/euro at $1.25 and yen/dollar at ¥120.
In the fourth Surprise, I expected further strength in the Japanese equity market as the economy shows that it is pulling out of its 20-year deflationary recession.
China is the focus of the fifth Surprise. In the Third Plenum meeting in November, China’s leadership pledged reforms to deal with corruption and programmes to reduce the importance of credit expansion in the growth of the economy. The objective is to increase consumer spending as a percentage of GDP and lessen investment in state-owned enterprises and infrastructure. Right now investment spending accounts for 45 per cent of GDP and the consumer for 35 per cent.
Various authoritative studies have shown that it will be difficult to accomplish this shift without reducing the growth of Chinese GDP from 7.5 per cent to something nearer 6 per cent for 2014A slowdown of this magnitude would have both social and political implications and it will be important to watch whether the new leadership group has the political will to risk the public reaction to slower growth and less job creation.
Many investors are optimistic that the increased production of oil using hydraulic fracking processes will bring North America toward energy self-sufficiency by 2020. There are others who think that increased production from Iraq and Iran will change the supply/demand balance and we will see lower oil prices in 2014. I am skeptical, and in the seventh Surprise I said that the price of West Texas Intermediate crude would rise to $110 a barrel in 2014. At present, worldwide demand for oil (primarily from the developing world) is increasing faster than worldwide production, and that is why I expect an increase in oil prices this year.
Finally, in the tenth Surprise, I expected the Affordable Care Act to have a turnaround. I recognised that the launch of the plan was disastrous because of technology failures. I believe those are fixable. More serious is the failure of young, healthy working people to sign up for the programme. That must happen if universal health care is going to succeed. I believe incentives will be initiated if young people do not sign up on their own. So, there they are, The Ten Surprises. Now let’s see how the year turns out.
Byron Wien is the Vice Chairman of Blackstone.