As the New Year gets under way, Gary Dugan, who is the chief investment officer for Asia and the Middle East at Coutts, the private bank, gives his thoughts about what is on offer from the world economy and markets.

As the New Year gets under way, Gary Dugan, who is the chief investment officer for Asia and the Middle East at Coutts, the private bank, gives his thoughts about what is on offer from the world economy and markets.

How high could the US 10-year government bond yield rise?
US 10-year government bond yields ended 2013 126 basis points (bps) higher than they started the year. In the latter stages of 2013, after the Federal Reserve decided to start trimming quantitative easing (bond purchases), the 10-year bond yield moved up 20 basis points. The spread between the 10- year and 2-year bond yields is at 280bps, which is close to the top end of the range seen over the past 25 years.

Hence, it would be a surprise to see 10-year government bond yields rise much further than this unless there is a change in market expectations of when the Federal Reserve will start to raise interest rates.

Isn’t the US equity market fully valued?

The very simple answer is yes. However, a full valuation of an asset class never stopped it from getting overvalued. The world is still awash with cash and developed market interest rates are close to zero. Liquidity factors still have the ability to push markets to new highs and to marked overvaluation. The S&P 500 trades on a historic price/earnings multiple (PE) of 17.3x, based on trailing 12- month earnings.

Were the market to trade on the average PE since 1990 (a period which includes a bubble or two), then that would provide around 10 per cent upside from here. Add in the forecast earnings growth for the market in 2014 and you could argue for a target for the S&P 500 of 2,150, some 17 per cent higher than where we stand today. Don’t get us wrong; 2,150 is not our target but it gives some sense of the potential upside if excess liquidity were to remain a feature of the market in 2014.

Could this be the year of emerging markets, as much as 2013 saw developed markets perform well?
The underperformance of emerging markets versus developed markets in 2013 is well documented. However, what is even more surprising is that emerging-market equities have significantly underperformed developed-market equities from the lows of 2009. In dollar terms, emerging markets are up 85 per cent from the lows while developed markets are up over 110 per cent. We believe the factors in favour of emerging markets will come more to the fore as we progress through 2014. Emerging markets have much lower debt levels relative to gross domestic product than developed markets, stronger potential growth and - after a year of marked underperformance - much cheaper valuations.

Where are the real outliers for marked capital gains?
They probably lie in emerging markets. In India a possible significant win for the Bharatiya Janata Party in the general elections in April could bring a wind of change the like of which India has not seen for some considerable time. Investors may rush to anticipate such a political shift, which could push the equity market higher. In China, the more that investors believe in the better quality and sustainability of future growth the greater the possibility of the market re-rating. Crucial will be the outlook for the financial sector, which remains the cheap part of the equity market and over which there remain considerable question marks. The real outlier among emerging markets is Brazil. The equity market fell 15 per cent and the Brazilian real fell 13 per cent against the dollar. Any spark of better news could bring about a smart recovery on both fronts, although the political environment remains a significant headwind to recovery.

What are the greatest downside risks to markets?
A spike in inflation: There is an understandable complacency in market inflation expectations. In the developed world inflation has remained very well behaved. The US Federal Reserve’s preferred measure of inflation is at 1.1 per cent versus a target of closer to 2 per cent. It is quite a stretch to believe that inflation could rear its ugly head and become a problem for markets. However, it would come as such a surprise it could easily lead to a more marked increase in bond yields and a much earlier start to increases in US policy rates.

Lack of sustainability in global growth: The global economy is doing well at the moment. However, there is always the risk that growth rolls over and policymakers are again left scratching their heads wondering how to rebuild momentum. In Japan the increase in the sales tax could bring consumer-spending growth to a halt, while in the US a lack of household income growth and tentative corporate spending and hiring could lead to disappointments in the second half of the year.

Should I give up on gold?
You don’t stop buying home insurance because your house didn’t burn down. And the insurance premium just got 30 per cent cheaper. We still believe gold has a role to play in portfolios. At around $1,200 per ounce gold offers good long-term value, particularly when you consider that the marginal cost of producing it is around $1,050 per ounce. We wouldn’t want to worry you by listing all of the things that could go wrong in the world although it is worth pointing out that on IMF numbers the government debt-to-gross domestic product ratio of the world’s major economies is not showing signs of coming down.

Where is the greatest risk of losing money?
We believe that bond markets will continue to be challenged even by a modest tightening of monetary policy by the Federal Reserve. While we don’t expect a repeat of 2013, when the US 10-year bond yield rose 126bps, there is still the risk of capital losses offsetting at least some of the income.

You have to be careful with Japanese equities. In 2013 the market returned a massive total of 59 per cent, although the return is not built on the soundest of foundations. Prime Minister Shinzo Abe has still to deliver meaningful reforms. We believe that without reforms, the economy will not be able to overcome the ticking time bomb of a declining population. Recently released data shows that the Japanese population shrank a further 244,000 in 2013. Shrinking populations inevitably lead to shrinking GDP – a poor backdrop for equity investment.