It was another strong year for share markets.

World share markets have performed extremely well in 2013.  As the year draws to a close, the MSCI All Country World Index (comprising both developed and emerging share markets) is on track to produce returns well above 20 per cent for the year for Australian investors.  Investors in Australian shares have enjoyed returns above 21 per cent so far this year.

It was a more challenging year for bond investors.  The sharp falls in bond yields across much of the globe during the aftermath of the global financial crisis led to very strong returns from bonds. However, yields in most major bond markets have moved higher this year, which has meant returns from both Australian and global bonds have been very modest.

There was still plenty to concern investors this year and the old saying, “share markets climb a wall of worry”, was clearly demonstrated.

The performance of the global and domestic economy gave markets little to cheer about.  Economic growth in the US remained disappointing, and growth in China and India, as well as elsewhere in the emerging world, has clearly slowed, despite some better data from China lately.

Conditions in Europe showed some signs of life this year, partly reflecting the confidence-boosting statements and measures announced by the European Central Bank in 2012. These helped to bring down key borrowing rates across the troubled economies of the Eurozone.  But while economic growth returned to the Eurozone in the first half of 2013, economic conditions across much of peripheral Europe are still dire.

Economic growth in Australia also remained weak and unemployment drifted higher. There are still concerns about our economy’s ability to maintain reasonable growth in the face of a slowdown in mining investment. These concerns, and a stubbornly high Australian dollar, have worried the Reserve Bank of Australia enough for it to cut official interest rates to their lowest level in many decades, 2.5 per cent.

In the US, 2013 showed just how dysfunctional policymaking in Washington has become. In early January the US economy narrowly avoided the so-called ‘fiscal cliff’, a large, automatic tightening in fiscal policy that could have seriously derailed US economic growth.

Later in the year, Congress and the White House failed to agree on even a temporary budget that would fund the US government and raise the debt ceiling. The US government partly shut down for several weeks in October and the world faced the threat of the US Treasury having to default on its obligations, which would have been catastrophic for world financial markets. A last minute deal was stitched together, but there is still no lasting solution.

The outlook for US monetary policy also generated much uncertainty in markets this year.  Early in 2013, there were suggestions that, given the apparent improvement in the US economy, the US Federal Reserve (the Fed) might start to wind back, or ‘taper’, its massive program of monthly asset purchases (or ‘quantitative easing’) earlier than expected. This was enough to send chills through global share markets, causing bond yields to rise sharply, and unsettling a number of emerging economies and currencies that had benefited from the extraordinarily loose monetary policy.  The ‘will they or won’t they?’ debate on tapering persisted throughout 2013.

The possibility that the Fed would taper provided support for the US dollar which in turn helped to lower the Australian dollar, which boosted returns from unhedged global shares. It also eased some of the pressure facing Australian export and import-competing industries.  Despite this, the Australian dollar remains overvalued and in our view, vulnerable to further falls in a range of potentially difficult environments.

The improvement in returns this year will be a relief to many investors, particularly retirees. But many important issues around the world remain unresolved and the investment environment uncertain. The ongoing farce that is US fiscal policy and the continuing structural problems in the Eurozone are just two of many sources of stress for financial markets.

 

Central bank action has clearly supported share markets over the last year. If that support continues, we could still see share markets rise. On the other hand, share markets could struggle if central bank support is withdrawn too soon or too aggressively.