By comparison with the previous two years, 2014 was a dull vintage for UK equities. The newsflow was neither bad enough to precipitate a correction, nor good enough to prolong the euphoric recovery rally of 2012-13. As of mid-December, the FTSE All-Share index was up about 2 per cent over one year - a massive underperformance of the S&P 500, up nearly 15 per cent.
Before we write off 2014 as a year to forget, however, let's readjust our expectations. Add in dividend income and the so-called 'total return' on UK shares is about 6 per cent for the past year. Moreover, inflation is exceptionally low - consumer prices were up just 1.3 per cent over the year to October - so, in real terms, UK equity investors haven't done badly. The average real return on UK equities for the past 100 or so years has been 5.3 per cent, according to painstaking research by academics Elroy Dimson, Paul Marsh and Mike Staunton. Assuming no Yuletide crash, therefore, the result for 2014 looks set to be just a smidgen below average. It's only in comparison with the bonanza of 2012-13 - which was never sustainable - that 2014, at the headline level, has been dull.
That headline result also masks a couple of significant reversals. The first was in March. For the first couple of months of the year, retailer and housebuilder shares rallied strongly, prolonging the 2013 trend, while the FTSE 100 multinationals were hit by poor sentiment towards emerging markets. That trend unwound in the spring and summer months, as investors began to worry about UK monetary policy. A growth-dampening 'polar vortex' in the US and hawkish comments from Mark Carney, governor of the Bank of England, reinforced a new consensus that the UK would be the first major Western economy to increase interest rates after the financial crisis. Investors fled to the comfort of blue-chip stocks, and large-caps started to outperform mid-caps.
This consensus, in turn, unravelled after the summer recess. As fears mounted that the UK economy was coming off the boil, economists began to push back their expectations for rising rates. The US is now expected to react to accelerating growth by tightening sooner, with the UK following only in 2016. Housebuilders have promptly rebounded strongly since August, followed more recently by retailers and other consumer cyclical stocks. Sentiment now is only slightly more cautious than it was a year ago, with investors seemingly looking forward to 'goldilocks' conditions in 2015 - the economy neither too hot to prompt rate increases, nor too cold to make consumers and businesses cut back.
The other significant reversal was in September and early October, when markets recorded their most dramatic correction of the year, falling nearly 10 per cent. The most convincing explanation for this sudden volte-face in market sentiment was faltering growth in the eurozone. Caught out by the slowdown in emerging markets and cutbacks in capital spending, master-exporter Germany suddenly found itself staring down the barrel of a recession, following poor industrial output data. But the growth fears prompted the usual dovish noises from central banks, including the Bank of England, and the market bounced back - even though little has changed.
It's worth dwelling on this point. In his market review a year ago, my colleague Simon Thompson identified eurozone deflation as a key risk for 2014, and thus it remains as we look ahead to 2015. Mario Draghi, head of the European Central Bank (ECB) in Frankfurt, shows every sign of understanding the problem. But German opposition to the purchase of government bonds - so-called quantitative easing, which has turned into the chief reflationary policy weapon in the US, UK and Japan since 2009 - seems to have survived the German economic slowdown unscathed. That leaves Draghi with more bark than bite, as this month's ECB meeting underlined. The governing council could only agree to declaring that it "intends" to expand its balance sheet by buying bonds - previously, it "expected" to - despite the eurozone inflation rate plunging to a five-year low of 0.3 per cent in November.
Chief among the deflationary forces is the falling price of crude oil. Whether the 40 per cent decline in the Brent benchmark since the late June peak - which has come in spite of simmering tensions in Russia, Syria and Iraq - is positive or negative for stocks is hotly debated. James Henderson, manager of the Lowland Investment Company, expects earnings upgrades, on the basis that brokers have yet to factor falling costs into their forecasts for energy-intensive industrial companies.
But this cuts the opposite way for BP (BP.) and Shell (RDSB), whose shares have fallen 19 per cent and 13 per cent respectively since July. Dennis Jose, an equity strategist at Barclays, reckons a one-dollar fall in the Brent benchmark cuts their earnings by roughly 1 per cent. That suggests there are big oil-related downgrades ahead as well as upgrades. And since the two oil majors together make up nearly 8 per cent of the FTSE All-Share index, their performance has a disproportionate impact on the headline numbers. That's a major reason why the City has underperformed Wall Street so badly this year.
Consensus forecasts currently imply 11 per cent earnings growth in the UK next year, following 5 per cent growth in 2014 (although this may yet change) and a 3 per cent contraction in 2013. Analyst forecasts almost always prove too optimistic - they were factoring in 8 per cent earnings growth for 2014 back in February. But profits do have scope to rise, if only judging by their historical share of UK output. They currently account for just over 14 per cent of GDP, compared with a 50-year average of 15 per cent, according to Capital Economics.
Earnings growth is key to the outlook for UK equities, because the valuation case for buying at today's levels is evenly balanced. UK shares trade on about 15 times historic earnings, roughly in line with the 40-year average. On a cyclically adjusted basis - taking 10 years of earnings rather than just one - the multiple looks more reasonable because earnings have been weak (see chart). It's worth stressing that UK stocks are nothing like as expensive as their US peers. But this was also true a year ago, since when UK stocks have underperformed. Valuation is only ever one piece in the jigsaw, particularly at shorter investment horizons.
As in previous years, the most compelling case for buying equities remains the absence of mainstream alternatives. Bonds remain overbought due to central bank purchases, and cash is yielding next to nothing. Regional property is certainly attractive, but is often a very hands-on investment. Against such a backdrop, another dull 6 per cent from UK equities next year would be most welcome.
