The gains look justified on valuation grounds, too, as financial markets return to some form of normality after enduring a rollercoaster rise in 2011 and 2012, when flare ups in the eurozone and risks of a US debt default sent risk aversion and the equity risk premium rocketing.
However, the absence of a sovereign bond default by the heavily indebted periphery southern European countries, coupled with strong economic data emerging from both the US and UK, has put a rocket under equity prices on both sides of the Atlantic as investors bet on the recovery proving sustainable. Earlier this month, the Office for Budget Responsibility upgraded UK economic growth forecasts to 1.4 per cent for 2013, much higher than the anaemic 0.6 growth it predicted in March, and now expects 2.3 per cent GDP growth in 2014, a full 0.5 percentage points higher than only nine months ago.
This pick up in economic activity can only be good for corporate profits, which partly explains the sharp rise in the UK stock market. But it also reflects higher earnings multiples paid for equities, driven by a fall in the equity risk premium, as investors feel more comfortable holding the asset class. And with government bond markets bottoming out, as investors rightly factor in a scaling back of the central bank money printing programmes of the US Federal Reserve and the Bank of England, expect a further compression of the equity risk premium as the gradual rotation from bonds to equities gathers pace.
That's not to say that equities will prove a one-way bet this year. There are several risks which could cause a market correction in the year ahead and it’s only right to address these in turn.
The most obvious risk to equities is what will happen when the US central bank, the Federal Reserve, starts tapering its bond purchases. Irrespective as to whether this happens at the Federal Open Market Committee this week, or in March next year as the consensus predicts, it is clear that markets are already factoring in the possibility. That is quite a contrast to the situation in May, when outgoing Federal Reserve chairman Ben Bernanke dropped the tapering bombshell and prompted a sharp sell-off in equities across the globe, and in emerging markets in particular.
After a strong recovery in equity markets since then, the key difference now is the starting point for any tapering, since 10-year US government bond yields are now nearer 3 per cent compared with less than 2 per cent in May. Investors also seem to better understand the significant difference between a tightening of monetary policy and tapering, which is a continuation of existing easy money policy, albeit at a reduced rate.
Moreover, under Janet Yellen, the new chair of the Federal Reserve, the forward guidance given to the markets will be further refined and there is now a general expectation that rate rises are at least a couple of years away. In other words, there is far less scope for a shock to the system as soon as tapering begins in the all-important US financial system. That’s because the likely impact of tapering on longer-term interest rates is now much less than seven months ago given the subsequent rise in bond yields since May.
Eurozone deflation
The other risk to equity markets is that the eurozone enters a deflationary pricing environment. European Central Bank (ECB) chairman Mario Draghi warned of such a scenario when the ECB cut interest rates to a record low of 0.25 per cent in November in order to maintain a safety margin against deflationary risks. The inflation rate in the eurozone has fallen to almost zero and prices have been dropping in a number of countries for most of this year, and not only the debt-burdened periphery of Portugal, Italy, Greece and Spain. Even France and Germany have seen falls. This is important because a permanent deflationary environment would make it impossible for heavily indebted countries, still nursing sizeable budget deficits, to reduce their debt burdens. In fact, debt-to-GDP ratios would continue to spiral beyond the point of no return. Let's hope that the ECB is on guard to take whatever action is needed to drive inflation up to mitigate this threat.
Ultimately, that could mean a full-blown quantitative easing (QE) programme by the ECB, albeit one that should have been instigated three years ago when the eurozone debt crisis was in its infancy. It may seem perverse, but such a money printing exercise to extinguish the deflationary threat would be positive for equity markets in the region, in the same way that the government bond buying programmes in both the UK and US have benefited stock markets over the past five years. It would also have positive knock-on effects for UK markets since the eurozone is a major trading partner.
