Five key challenges for equity investors in 2014

Equities have returned over 6 percent in 2013 with the Sensex and Nifty returning 8 percent and 6 percent, respectively. Equity markets have gone against the trend in the bonds and rupee markets as bond yields rose 100bps and the rupee depreciated 12 percent against the dollar.

In fact, FIIs bought $20.7 billion in equities and sold $7.5 billion in debt in calendar year 2013, indicating the positive equity stance and the negative bond stance.

Equity investors have had a good run in 2013 with the Sensex and Nifty closing at close to record highs. Global equity investors have had an even better run than Indian investors with returns ranging from 57 percent for the Nikkei to 37 percent for the Nasdaq, 30 percent for the S&P 500 and 25 percent each for the Dow and the Dax. Global equities have outperformed bonds that have seen 50bps to 130bps rise for ten-year German Bunds and ten-year US Treasuries. Equities have outperformed gold that has given 28 percent negative returns and oil that has stayed almost flat in 2013.

Emerging equities have underperformed developed market equities with China and Brazil showing negative returns and Korea and Hong Kong just managing to stay positive. India has been one of the best performing emerging equity markets in 2013.

How is calendar year 2014 looking for equity investors? The fact that the Sensex and Nifty are at record highs at a time when the country is going into elections in 2014 and at a time when economic growth is at decade low levels of 5 percent and inflation at the consumer price levels is at record highs of 11.24 percent is a worry for investors.

Record high levels of global equity indices with Dow, S&P 500, Dax at record highs and Nikkei and Nasdaq at multiyear highs is also a worry for investors as any correction in these markets could pull down equities across the globe. However, given the positive momentum in markets on the back of low interest rates, low inflation, high liquidity and improving economic conditions in the US, Europe and Japan, equities look to be strong in 2014.

Equities at record high levels are always a worry, especially when there are economic and political risks. Equity investors should keep a wary eye on the market even if markets are looking more positive than negative. Identifying factors that could affect the market negatively would help investors reduce risk.

What are the key challenges faced by equity investors in 2014? Here is a list of five key factors that will affect equity markets in 2014.

1. Economic recovery falters in the US: US economy has seen signs of strength in 2013 with unemployment rate down to five-year lows of 7 percent, GDP growth at 4.1 percent for the third quarter the highest seen in last seven quarters, inflation well below Fed threshold levels of 2.5 percent, rising home prices, double digit growth in automobile sales, highest oil production growth ever and improved consumer and business confidence. The Fed has helped the US economy with $85 billion of bond purchases a month and close to zero percent policy rates. The Fed is in the process of withdrawing stimulus gradually. The US economy has been driving markets globally and if the economy falters on the back of government budget cuts, weak global economy and lack of follow through buying by consumers, markets could see a sharp correction.

2. China pulls down global economies: The China effect on commodity prices is seen in flat to negative trends in commodity equity indices and currencies. Brazil has returned negative 15 percent in equities given its high commodity weights while the Australian Dollar is down 17 percent year on year. China equities have shown negative returns in 2013. China is grappling with lack of domestic demand and property price bubbles and with reforms, interest rates have risen sharply. China’s economic growth at around 7.5 percent to 8 percent levels is below double-digit growth levels seen in most of 2000-10 decade. China growing at a slow pace could bring down growth in exporting nations leading to weak global growth and falling equity markets.

3. Sovereign debt issues cropping up globally: The high debt levels in the US that saw the country being downgraded by a notch from AAA to AA+, unsustainable debt levels in Eurozone countries (Portugal, Ireland, Italy, Greece and Spain), high debt levels in Japan at over 200 percent of GDP and high debt levels in countries in other parts of the world are always an overhang on markets. Debt issues keep cropping up with the last case of jitters taking up bond yields in Europe sharply higher. Efforts by the central bank and government to calm markets have borne fruit with bond yields sharply off highs seen in 2012 but given that debt levels in absolute terms are not coming off but actually going up, there could be periods of high volatility in global financial markets leading to risk aversion and money being pulled out of risk assets.

4. Banking sector in India struggles to cope with bad assets: Banks in India have been struggling with NPA (non-performing assets). Bad loans have grown at 28 percent CAGR while restructured assets have grown at 41 percent CAGR over the last four years. The RBI believes that bad loans are still a big problem for banks and if bad loans grow at similar rates, there will be a sell off on bank stocks.

5. The Indian government does not embrace fiscal reforms: India will see a new government in 2014 as general elections are slated for May. The economic policies of the government will be critical for markets and if the government does not embrace deficit reduction policies, risk on equities would trend higher.

Arjun Parthasarathy is founder Investors are Idiots.com and INRBONDS.com. Follow him on twitter

@arjunparthasara