The purpose of The Ten Surprises is to stretch the thinking of investment professionals so they consider events beyond the prevailing perceptions that could have an impact on the financial markets in the year ahead. My definition of a surprise is an investment-influencing event that most money managers would only assign a one-out-of-three chance of happening but which I believe is “probable,” meaning the event has a better than 50% chance. Not all of the Surprises are contrarian. Some are in the direction of the consensus but more extreme.
While I am more interested in the thought process that relates to the various surprises, this is Wall Street, where a score is kept on everything. I have been preparing The Ten Surprises for 28 years and I usually get five or six pretty much on the mark. I have had a number of years when I got seven nearly right and in 2009 I scored nine. As in any endeavor of this sort, there are bad years also, and 2013 was one of them. While it was not a total washout, it was below average. The year 2012 had been a good one for the markets (and the Surprises) and I thought that 2013 would be more difficult. As it turned out, for the developed markets, last year was remarkably strong. The economies in the United States and Europe had a more uninspiring time, however. Earnings grew slowly and a lack of demand caused revenues to expand even more modestly than most observers expected. The accommodative monetary policies of the Federal Reserve and other central banks provided the liquidity necessary for the increase in price earnings ratios, and markets in the United States, Europe and Japan did well.
By year end, there was hope on the geopolitical front as well. A deal with Syria to surrender its chemical weapons and another with Iran to limit its nuclear development program were underway. On the domestic front Congress approved a budget and the debt ceiling was likely to be raised. The Affordable Care Act however, was off to a bad start. During the third and fourth quarters, there were signs that the U.S. economy was gaining some momentum. While little progress was made on the income inequality issue and 7% of Americans seeking employment were still out of work (almost 14% were in part-time jobs looking for full-time positions), the mood at Christmas was generally positive. The Federal Reserve began to reduce its bond buying, housing starts exceeded one million units and an optimistic view of 2014 prevailed as we entered the new year.
Now for a review of The Ten Surprises of 2013 and the list for 2014. Some clients have told me that there is more information content in the ones I get wrong than the ones I get right. I certainly hope so because I got most of the Surprises wrong last year. In the first Surprise I said that Iran would announce that they had enough nuclear material to produce a bomb and that the International Atomic Energy Agency would confirm the claim. Israel and the United States would have to shift to a policy of containment. While Iran made no such announcement with respect to nuclear material, many believe the country is close. As a result, there is a school of thought that the sanctions were working and so therefore the U.S. should have pressed for Iran to abandon its nuclear efforts. I believe, however, that this was unlikely to happen. Others worry that Iran will be uncooperative along the way (there are signs of that now as they restrict observer access to certain sites), but we have a deal that runs for six months and we should see if they have complied at the end of it. I would say I was partially right on this one.
In the second Surprise I said that this would be a tough year for earnings and the market would respond unfavorably. I expected profit margins to peak (they edged up slightly) and revenues to grow somewhat, causing the Standard & Poor’s 500 earnings to fall below $100 (they are likely to be $108). Revenues were disappointing (up 2%) and earnings did grow (up 4.7%), but corporate net income was less impressive. Share buybacks played a major role in earnings per share growth, with the total the highest since 2007. The total return of the S&P 500 of over 32% was certainly a surprise to me. If I had only seen the sharp rise in the market, I would have been pretty much alone among strategists and that would have made up for a lot of Surprises that didn’t work out.
The third Surprise followed the second. I thought the financial stocks would have a tough time because of intense competition, over-capacity, increased regulation and lawsuit settlements. All of those factors came into play during the year but many financial stocks performed well in spite of that because of the strong equity market.
The fourth and fifth Surprises were political in nature. In the fourth I said that President Obama would embrace an ambitious energy policy. U.S. energy production did continue to rise, and attitudes toward hydraulic fracking, harnessing the natural gas flare-off for productive purposes and extending the Keystone pipeline all remained neutral or moved toward positive. I cannot say that the Administration made energy a primary focus of its agenda, however. As for the fifth Surprise on immigration, little progress was made. The president spent the year fighting with Congress over the budget, the debt ceiling and the Affordable Care Act and there was very little time for anything else. The long-hoped-for revision in the tax code went nowhere. It turned out to be one of the least productive legislative sessions on record.
The sixth Surprise concerned China, where I expected the new leaders to focus on rebalancing the economy toward the consumer, reducing official corruption and maintaining growth in excess of 7%. I expected Chinese mainland traded equities to appreciate by 20% during the year, which did not happen. I also thought the new leadership would improve the country’s healthcare and retirement programs. While there is talk of this I believe few initiatives have come forth.
I thought the combination of global warming producing variable weather conditions and resultant crop failures coupled with increasing demand for better diets from the developing world would cause agricultural commodity prices to rise. I expected corn, wheat and cattle futures to move higher. They ended up the year well short of my projections; crop realizations were strong, keeping prices low, even though demand from the developing world continues to increase.
I did think inflation would remain tame during the year but I expected gold to rise. This was my worst call, since gold collapsed in the spring. My reasoning was that central banks in the major industrialized countries would continue to debase their currencies and investors would want to protect the purchasing power of their portfolios by owning something “real” like gold which has been a store of value for thousands of years. What I underestimated was the amount of speculation that had occurred in driving the price to $1900 an ounce. When the price began to decline, the selling pressure from individuals became intense. Much of the physical gold was bought by Indian and Chinese investors who will probably hold it for the long term. As a result the price should rise sharply if interest in the metal ever comes back.
I finally got one clearly right in the ninth Surprise, but even then I did not go far enough. I said the Japanese market would be strong and the yen would decline. I got the yen right, but the market did better than I thought it would.
Finally in the tenth Surprise I said that the structural problems in Europe would remain unresolved and the recession there would continue. I expected the European Union to continue intact in spite of this, but I thought the equity market there would decline, which it did not.
Although the performance of last year’s Surprises was disappointing I plan to continue turning out an annual list for as long as I am able. As Yogi Berra allegedly said, “Forecasting is difficult, particularly about the future.” Thinking about what unexpected events might happen in the coming year stimulates the creative process and that is always useful for investors. I work on the Surprises over several months and I seek the views of many others in the process. I want to thank my Third Thursday Group of former research directors of Wall Street firms (plus a few newcomers); Gideon Rose and Jonathan Tepperman of Foreign Affairs and others at the Council on Foreign Relations; Ian Bremmer of Eurasia Group; the energy expert Tom Petrie; Richard Chilton and others at the Chilton asset management firm; George Soros, who has discussed the Surprises with me since the 1980s; and other friends, acquaintances and colleagues who have provided useful suggestions. In the end, however, I take total responsibility for the Surprises, right or wrong.
The Surprises of 2014
1. We experience a Dickensian market with the best of times and the worst of times. The worst comes first as geopolitical problems coupled with euphoric extremes lead to a sharp correction of more than 10%. The best then follows with a move to new highs as the Standard & Poor’s 500 approaches a 20% total return by year end.
2. The U.S. economy finally breaks out of its doldrums. Growth exceeds 3% and the unemployment rate moves toward 6%. Fed tapering proves to be a non-event.
3. The strength of the U.S. economy relative to Europe and Japan allows the dollar to strengthen. It trades below $1.25 against the euro and buys 120 yen.
4. Shinzo Abe is the only world leader who understands that Dick Cheney was right when he said that deficits don’t matter. He continues his aggressive fiscal and monetary expansion and the Nikkei 225 rises to 18,000 early in the year, but the increase in the sales tax, the aging population and declining work force finally begin to take their toll and the market suffers a sharp (20%) correction in the second half.
5. China’s Third Plenum policies to rebalance the economy toward the consumer and away from a dependence on investment spending slow the growth rate to 6% in 2014. Chinese mainland traded equities have another disappointing year. The new leaders emphasize that their program is best for the country in the long run.
6. Emerging market investing continues to prove treacherous. Strong leadership and growth policies in Mexico and South Korea result in significant appreciation in their equities, but other emerging markets fail to follow their performance.
7. In spite of increased U.S. production the price of West Texas Intermediate crude exceeds $110. Demand from developing economies continues to outweigh conservation and reduced consumption in the developed world.
8. The rising standard of living and the shift to more consumer-oriented economies in the emerging markets result in a reversal of the decline in agricultural commodity prices. Corn goes to $5.25 a bushel, wheat to $7.50 and soybeans to $16.00.
9. The strength in the U.S. economy coupled with somewhat higher inflation causes the yield on the 10-year U.S. Treasury to rise to 4%. Short-term rates stay near zero, but the increase in intermediate-term yields has a negative impact on housing and a positive effect on the dollar.
10. The Affordable Care Act has a remarkable turnaround. The computer access problems are significantly diminished and younger people begin signing up. Obama’s approval rating rises and in the November elections the Democrats not only retain control of the Senate but even gain seats in the House.
Every year there are always a few Surprises that do not make the Ten either because I do not think they are as relevant as those on the basic list or I am not comfortable with the idea that they are “probable.”
1. Through a combination of intelligence, extremism, celebrity and cunning Ted Cruz emerges as the clear front runner for the 2016 Republican presidential nomination. Chris Christie and the moderates fade in popularity as momentum builds for fiscal and social conservative policies.
2. In 2½ years the price of a Bitcoin has increased from $25 to $975. The supply of Bitcoins is fixed at 21 million with 11.5 million in circulation. Bitcoins lack gold’s position as a store of value over time. During the year Bitcoin’s acceptance collapses as investors realize that it cannot be used as collateral in financial transactions and its principal utility is for illegal business dealings where anonymity is important.
3. Overcoming objections from the Cuban exile community, President Obama opens discussions on initiating trade and diplomatic relations with Cuba. A reduction in sanctions is proposed, as well as limited financial support in the form of bonds, quickly dubbed as “Castro convertibles.”
4. Hillary Clinton decides not to run for President in 2016. She says her work with various Clinton not-for-profit initiatives is important and unfinished. Specifically, she explains that her health was not an issue in her decision. The Democratic race for the top seat becomes chaotic.
Next month I will discuss the reasoning behind each of The Ten Surprises of 2014.