World economies pose biggest risk in 2014

China, eurozone could still shock markets in coming year

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The prevailing view for 2014 is that the world is a safer place for investors than it's been for the past six years. The U.S. economy is in a sustainable recovery, the risk of a financial crisis in Europe is low and China's growth is still apparently intact.

But some analysts get nervous when they see so many of their peers with identical views. History has shown that professionals have been the most blind to risks just before a stock market nose dive. That's why some consider the blissful attitudes of investment advisers in a recent Investors Intelligence poll to be a yellow flag.

"Complacency is a source of concern," said Gluskin Sheff economist David Rosenberg. He notes that bullish, or optimistic, advisers make up 61.6 percent of the investment professionals polled. That's the highest level of optimism since October 2007. And there are very few professionals worried about the stock market. Only 14 percent of advisers polled are bearish — the least since March 1987.

Those dates have to get your attention: High optimism preceded the horrific 57 percent decline in the market that began in 2007, and low bearishness preceded the 22 percent Black Monday plunge of 1987.

One of the precepts of investing is to continually discipline yourself to watch for risks, and then hold a broad mixture of stocks and bonds so you have insulation in case a shock hits without warning.

One risk, Rosenberg said, is that analysts have "very large expectations" for corporate profits. The consensus is for 10.5 percent earnings growth in 2014, which would be double 2013's 5 percent and a high bar given still modest GDP growth and anemic sales growth. Concerns about upcoming earnings announcements may have been why stocks started 2014 with three declining days before the Dow Jones industrial average climbed 105.84 points Tuesday.

Throughout January, companies will be reporting their fourth-quarter earnings, and investors aren't likely to be forgiving if companies reveal that expectations were too lofty. With stocks no longer cheap after climbing 30 percent in 2013, profit disappointments could set off a correction in the stock market. Still, strategist Ed Yardeni notes that's probably unlikely, since companies intentionally get analysts to lower expectations before earnings season so the companies can easily beat forecasts.

Another risk mentioned frequently is that as the Federal Reserve pulls away from stimulus, interest rates could rise more quickly than expected and disrupt the economy or scare investors. To anticipate the Fed's potential moves, watch unemployment numbers, including Friday's. The Fed has suggested that it will be less determined to hold interest rates down after unemployment goes below 6.5 percent.

Still, most analysts think the largest risks to investors this year will come from outside the U.S.

"The biggest risk for equities would be some exogenous shock from abroad, say China or even Europe," Rosenberg said. "Events overseas could influence risk appetite here at home even if there is little economic impact."

That was the case in 2011, 2012 and mid-2013, as the stock market dipped at times when China's growth was in question, or as investors feared that massive banking and debt problems would undermine Europe and China.

In 2013, investors regained courage about investing in the eurozone as Europe emerged from recession, and the European Central Bank calmed fears about a financial crisis involving government debt and banks. Countries like Spain are now borrowing money at low, affordable interest rates compared with crippling levels of around 7 percent in 2012.

Yet, Barclays economist Philippe Gudin noted in a recent report that concerns about eurozone banks and sovereign debts could bubble up again in 2014 because banks are still weak and there is no eurozonewide system like the Federal Deposit Insurance Corp. to step in and deal with banks that are insolvent. Yet, analysts tend to think that panic won't re-emerge over a European financial crisis, because there is a widespread belief that European Central Bank leader Mario Draghi and German Chancellor Angela Merkel will make good on the pledge to do "whatever" necessary to defend the euro.

Proposals on shoring up the European financial system will be debated in the European Parliament in 2014, and investors could be unnerved as some political nationalist groups in some countries resist helping other countries. But Gudin said that with elections planned in Europe in 2014, eurozone negotiations might be pushed to 2015. Meanwhile, Europe struggles to grow because troubled banks are reluctant to lend money, and individual countries such as France and Italy resist reforms that will be painful for workers.

Eurasia Group President Ian Bremmer said Monday: "Europe remains very much in the muddled middle, with neither reform/recovery nor crisis and eurozone collapse at all likely in the near future."

China, too, is in an unsettled state as the Chinese government has recently announced reforms that seem in conflict with each other.

"Reforms might prove to be very successful, improving China's investment climate and opportunities for integration in the world economy," Bremmer said. "Still, the government is loosening its hold on key reins of the domestic economy on a historic scale, and that could have serious unforeseen consequences."

The biggest economic risks, he said, are in the financial sector, where China's leaders recognize significant problems with bank solvency and are expected to try to curtail future sloppy practices by letting bad loans default without a bailout.

Bank of America Merrill Lynch's China economist team noted in a recent report that in 2014, growth in China could be more stable than in 2013, but the pace of growth has slowed to 7.6 percent.

Financial markets may be "volatile" in 2014, the economists said, because China will face debt risks and "overly rosy expectations on reforms."

Beyond these worries, the Eurasia Group is anticipating geopolitical tensions in the Middle East to continue throughout 2014, with potential disruptions in oil. Yet, the U.S. is less dependent on OPEC oil than it has been in the past because the U.S. has greatly increased domestic oil production.

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis

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