BIG PICTURE – During the previous year, the stock markets of the developed world consolidated whereas the majority of the developing nations performed poorly.

In 2014, the European stock markets essentially traded sideways, Japan produced modest growth and unsurprisingly, Wall Street delivered the best returns. Over in the developing world, the commodities producing nations (Brazil and Russia) fared badly, whereas China, India, Philippines and Thailand produced decent growth.

It is notable that over the past 12 months, a number of our expectations were met as the US Dollar strengthened, the Euro and Japanese Yen weakened considerably, stocks in the US did reasonably well, high yield bonds ended their epic bull run and commodities as well as precious metals took it on the chin! Finally, over in the emerging world, both of our preferred stock markets (China and India) did very well.

So, as we start this year, we wish to set out our expectations for the following 12 months.

Although there are no guarantees in the investment business, we are of the view that last year’s trends will probably continue over the following months, so you may want to remain over-weight stocks in the developed world. Elsewhere, we suspect that the US Dollar will continue to make headway against the majority of the world’s currencies and this will benefit American assets.

If you review Figure 1, you will note that the US Dollar Index has recently broken out of a huge trading range and climbed to a multi-year high! Usually, such breakouts are followed by explosive moves in the direction of the prevailing trend; so we should expect a big rally in the greenback. As you can see from Figure 1, at the turn of the millennium, the US Dollar Index topped out at 121.21 so at the current level (91.82), there is plenty of scope for additional gains.

Figure 1: US Dollar Index (weekly chart)

Source: www.stockcharts.com

If our assessment proves to be on the mark and the world’s reserve currency appreciates, it will drive capital to the US; thereby benefiting American bonds, real-estate and stocks. Furthermore, the ongoing strength in the American economy should also attract investors’ interest and this is why we recommend an over-weight position in the US.

Over in Europe, we suspect that at some point in the not too distant future, the ECB will unleash its own version of quantitative easing and this will drive up equities at the cost of the single currency. Remember, the European economy is still struggling and with the recent plunge in the price of oil, deflation has become a genuine threat. Thus, it is probable that the ECB will announce some form of ‘stimulus’ this year and it should benefit European stocks.

If you observe Figure 2, you will see that the Dow Jones Euro STOXX 50 Index is currently trading significantly below the highs recorded in 2000 and 2007; so there is sufficient upside potential for this recovery candidate. Should Mr. Draghi commence a wide scale bond buying program, European stocks will come to life. Accordingly, we recommend some exposure to this part of the world.

Figure 2: Dow Jones Euro STOXX 50 (monthly chart)

Source: www.stockcharts.com

Over in Asia, we continue to feel that the Japanese stock market will do reasonably well over the following months, so our readers may want to gain some exposure. After all, the Japanese policymakers are aggressively trying to stimulate the economy and this is driving up equities at the cost of the Japanese currency. Although we do not believe that Japan will regain its competitive edge anytime soon, we believe that quantitative easing will benefit local equities (especially, the exporters which become more competitive from a falling Japanese Yen). Thus, modest exposure to Japanese stocks is recommended.

In the emerging world, we are of the view that the commodity-producing nations will continue to suffer due to the ongoing primary downtrend in hard assets; so these stock markets may underperform over the following year.

Conversely, nations which are massive importers of oil will get tremendous assistance from the recent plunge in crude and their stock markets are likely to appreciate.

In terms of specifics, we believe that both China and India will benefit a great deal from the slide in the prices of commodities, so their stock markets should (once again) deliver good returns this year. It is worth noting that although India’s stock market has already appreciated by approximately 2½ times since the bear market low, China’s stock market (Shanghai Composite Index) has only recently come out of a 7-year bear market and it has appreciated by just 80% from the recent low! More importantly, the Shanghai Composite Index is still trading approximately 45% below its all-time high recorded in 2007; so there is lots of room for additional gains.

If you review Figure 3, you will see that the Shanghai Composite Index has just broken out of a 3-year trading range and once the 2009-high is overcome, we will probably get a big advance. Furthermore, you will observe that during the previous bull market, the Shanghai Composite went up approximately 600% in less than 3 years, so it is conceivable that we may also see some impressive fireworks in the current primary uptrend.

Figure 3: Shanghai Composite Index (weekly chart)

Source: www.stockcharts.com

China bulls may want to take heart from the fact that last month, investors on the mainland opened 2.7 million new stock trading accounts and since retail trading volume accounts for 80% of total transactions, this can only be seen as a positive development.

Although we do not possess a crystal ball, we believe that over the following months, we will witness an epic stock market mania in China! Similar to the last bull market, tens of millions of new trading accounts will probably open up and before it is all over, taxi drivers will proudly boast about their exploits in the stock market. Needless to say, when that happens, the bull market will be very mature and the painful end will be around the corner. Fortunately, we are still several months away from such a euphoric blow-off phase and in the meantime, there is a real opportunity to profit from China’s bull market.

Bearing in mind the above, we have allocated some capital to China’s A-Shares and over the past few weeks, these positions have produced a very good return. In the same vein, we suggest that our readers also consider getting some exposure to China’s domestic stock market.

Now that we have given you our outlook for the stock and currency markets, we want to briefly discuss the state of the commodities market. You will recall that we first turned bearish on the sector in late 2011 and since then, commodities have been in a persistent downtrend.

Even though prices have declined for almost 4 years, we suspect that we are only halfway through this primary downtrend. From our perspective, the macro-economic environment is not conducive to a sustainable bull market in commodities and this is primarily due to weak aggregate demand and ample supplies. More importantly, the US Dollar is in a primary uptrend and this should continue to weigh down on the commodities complex. After all, commodities are denominated in the world’s reserve currency, thus their prices are inversely correlated to the direction of the US Dollar. If the greenback continues to advance over the following months, this will probably create a significant headwind for commodities and precious metals. Accordingly, we believe that this is not the appropriate time to have any significant exposure to hard assets as the coming year will probably disappoint investors.

If you review Figure 4, you will note that last summer, the Reuters-CRB Index (CCI) sliced through an important area of support and by falling below the 500 level, it commenced another down leg in its primary bear market.

The CCI is currently trading at the same level as the 2010-low; so a near term bounce cannot be ruled out. However, the path of least resistance remains down and we are likely to witness further declines in the prices of commodities.

Figure 4: Reuters-CRB Index (weekly chart)

Source: www.stockcharts.com

In addition to commodities, we suspect that the prices of precious metals will also drift lower over the following year. Therefore, this may not be the best time to gain exposure to the metals.

Last but not least, as far as bonds are concerned, we are of the firm view that the high yield corporate bond market topped out last spring and we are now in the early stages of a lengthy bear market. Elsewhere, we believe that capital will continue to migrate towards US government bonds, so the ongoing rally will probably continue in 2015.

In summary, apart from the periodic counter-trend moves, we suspect that last year’s trends will continue this year, so our readers should refrain from swimming against the tide. For our part, we have allocated our managed portfolios to our preferred investment themes and it is our contention that these strategies will perform well this year.

Finally, in terms of sectors, we are seeing ongoing strength in the cyclicals (airlines, asset managers, auto parts, clothing, footwear, railways, retail and restaurants), therefore we have concentrated our equity portfolio in these areas.

The terrorist attacks in Paris have fixated the world’s attention on the contrast between competing worldviews and what constitutes acceptable behavior in modern society. What are the principles by which society should be organized and run? Who gets to set those rules, and to what standards should others who do not believe in them be held?

While at their core these are philosophical questions, the way we answer those questions can have profound economic consequences. They are especially important to understand in the context of Europe. For today’s Outside the Box reading, I think we should look at two essays by old friends to OTB, Charles Gave and George Friedman.

Charles writes as a patrician French patriot and examines the question “[Do] France and its neighbors have a part of their population that rejects the rules on which the nation is based and wishes to build a nation under a different set of rules?”

He offers a very nuanced and thoughtful analysis of the difficulty of answering that question by means of simplistic reactions. And he comes to the uncomfortable conclusion that

As far as France and most other Western nations are concerned, it is obvious that these questions will now more than ever (in spite of mainstream politicians’ best efforts to keep them out) enter the political stream and discourse. And instead of calming tensions in an era of great economic discomfort, this will likely amplify them.

George sees the problem in terms of geopolitical analysis and through the lens of history (emphasis mine):

The Mediterranean borderland was a place of conflict well before Christianity and Islam existed. It will remain a place of conflict even if both lose their vigorous love of their own beliefs. It is an illusion to believe that conflicts rooted in geography can be abolished. It is also a mistake to be so philosophical as to disengage from the human fear of being killed at your desk for your ideas. We are entering a place that has no solutions. Such a place does have decisions, and all of the choices will be bad. What has to be done will be done, and those who refused to make choices will see themselves as more moral than those who did. There is a war, and like all wars, this one is very different from the last in the way it is prosecuted. But it is war nonetheless, and denying that is denying the obvious.”

George has written a book called Flashpoints: The Emerging Crisis in Europe, which will not be available until later in January, although he graciously sent me a review copy. I’ll get started with that one but will also go ahead and buy it in a couple weeks, so I can read it on my iPad Kindle app. I find reading books on my iPad far more efficient and easy than toting around three or four books in a briefcase. I can highlight and make notes and have them available online anywhere in the world without having to go back and search through a book that I read years ago. I know that many people relish the feel of a physical book, and I admit to that pleasure; but the pain of not being able to find a specific quote or note, or worse, not being able to find the book at all because you lent it to somebody and it’s not back on your bookshelf, is far more of a driver to make me go almost totally online.

That said, when I found out that my flights to Cincinnati and back would not have on-board Wi-Fi, I did jump into George’s book. I think it’s his best work to date. It recalls to mind so many conversations we have had over the years about the tensions in Europe, and it’s giving me a deeper understanding of a region of the world that I am really quite fond of. I suspect we will revisit George’s work in future letters. It is especially relevant to the research I’m doing for my own current book-writing project on the future of the global economy.

Cincinnati is as the Weather Channel forecasted, cold and grey with snow flurries, as I look out my hotel window. That gloom aside, I spent several hours this morning visiting with friends who run a private biotechnology startup across the river. That was a decidedly ungloomy get together, as the optimism that a cure for cancer is potentially in the offing in the not-too-distant future was evident to us all, even as they explained the (to me very frustrating) process of securing regulatory approval. Hopefully that process will come to a reasonable conclusion sooner rather than later, given that over 1,500 people a day die from cancer in the US alone (many more actually contract cancer and undergo treatment and live). The savings in human lives brought about by a cure would be incalculable, but the savings in dollars to our healthcare system and the elimination of other economic losses caused by cancer would be in the hundreds of billions. And that is just in the US.

And on that hopeful note, let’s turn to Charles and George, where the news is not as optimistic. Have a great week!

Your pondering Europe analyst,

John Mauldin, Editor
Outside the Boxsubscribers@mauldineconomics.com