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The domestic economy is starting to show broad-based signs of strength and could be poised for accelerated growth. Most of the recent economic data releases have surprised to the upside: 3rd quarter GDP was revised to 4.1%, automobile sales are back to their pre-Great Recession levels, the unemployment rate continues its steady decline from over 10% in late-2009 to 7% today, consumer confidence is back to pre-financial crisis levels, housing starts have more than doubled in the past four years and the Index of Leading Economic Indicators is pointing higher. Despite the recent bipartisan budget agreement reached in Congress, we remain wary of the pending debt ceiling showdown between the two parties and the potential damage it could do to the economy’s current momentum. However, short of another dysfunctional Washington moment we believe the domestic economy is poised for strong growth in the coming year.
One of the few economic indicators that isn’t pointing higher is the Federal Reserve’s favorite measure of inflation, the Personal Consumption Expenditures Index (PCE). The year-over-year Core PCE Index is barely above 1%, other than the sub-1% level it hit in mid-1998 and again at the end of 2010 it stands at its lowest level in 50 years. The Fed’s minimum target for inflation is 2%. Given the current levels for the Personal Consumption Expenditures Index and most other conventional measures of inflation (Consumer Price Index, Producer Price Index, GDP Deflator), we don’t believe inflation should be a concern any time soon. In fact, the low absolute current readings and the disturbing downward trend makes us more concerned about deflation than inflation.
Based on the Fed’s most recent forecast, short-term interest rates will remain anchored near 0% for the next three years. Longer-term US Treasury yields, which rose over 1% in 2013, will likely continue rising in 2014. Treasury yields are comprised of two components: a “real” interest rate and an inflation expectation. As noted above, at present we are not concerned about the inflation expectation component. We are concerned about the still artificially low “real” interest rate. In 2013 the “real” interest rate rose 1.5% and investors’ inflation expectations actually declined 0.25%. Even with the 1.5% rise in “real” interest rates, we would need to see an additional 2% increase to get back to the historic average “real” interest rate. We believe the Fed’s tapering of its bond buying activities and then ultimately the shrinking of its balance sheet ($4 trillion today compared to never ever having been above $1 trillion prior to the financial crisis) will continue to drive “real” interest rates higher in 2014.
Domestic Equity Markets
Stock prices follow corporate earnings and we believe the corporate earnings environment remains positive particularly in light of our optimistic outlook for the domestic economy. We also believe stocks will continue to benefit from an overall reallocation from bonds to stocks by investors. Individual investors have been woefully underweighted in stocks since the financial crisis, and institutional pension plans will have a difficult time achieving 8% actuarial rates of return with any investments in investment grade bonds yielding 2.5%. The stock market still offers comparable yields, far more upside, and only slightly more downside than the investment grade taxable bond market. We are approaching the fifth anniversary of this bull market—it is typically at this stage we expect to see price-to-earnings multiple expansion. P/E multiples for the domestic stock market are about 5% below their historic average—it is not uncommon in the late stages of a bull market for those multiples to expand well past their historic averages. We believe the combination of stronger corporate earnings and price-to-earnings multiple expansion could fuel another double-digit return for the domestic stock market in 2014.
Domestic Bond Market
As noted above, we believe US Treasury bonds are a poor investment today as they still offer historically low yields, little upside and lots of downside risk as investors experienced this past year—the worst year for the domestic bond market in the past two decades, and only the fourth calendar year in the past forty in which the bond market delivered negative returns. Interestingly, 2013 was the only one of those four negative return years in which the Fed wasn’t pursuing a tight money policy. While we don’t anticipate it happening any time soon, an overheating economy and/or a spike in inflation expectations would likely lead to an even uglier bond market environment. Corporate bonds offer some value in that credit spreads still have some room to narrow further as the economic environment will likely be conducive to bolstering corporate balance sheets. Intermediate investment grade municipal bonds offer fair value, on an after-tax basis, versus taxable corporate bonds. Longer dated tax-exempt bonds, particularly in the lower ratings categories, offer significant value versus their taxable corporate bond brethren on an after tax-basis, and in some cases (10+ year high yield bonds) on a pre-tax basis. Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics.
Much of Continental Europe is still recovering from recession but most Eurozone economies are much better today than they were a year ago and the overall trajectory is encouraging. Likewise, the United Kingdom, which was at stall speed a year ago and Japan, which had negative growth a year ago, are both thriving today. The larger emerging market economies (Brazil, Russia, India and China) have seen their growth rates decline in recent years, but in most instances the slowdown appears to be at, or near, a bottom.
As is the case in the United States, we believe that deflation may still be a greater risk than inflation to the overall global economy. There are a number of emerging market economies struggling with elevated inflation rates but they also tend to be the economies with the highest growth rates.
As with the domestic market, we expect global short-term interest rates to remain low. Longer-term interest rates in most major markets are still near historic lows in large part because the “real” interest has been kept artificially low for several years now. We expect those “real” rates to adjust back to historic levels in the coming years which should keep upward pressure on most developed markets’ interest rates.
The dollar actually weakened modestly versus the British Pound and the Euro on the heels of the Fed’s tapering announcement—we see that as a short term anomaly tied to profit taking (buy the rumor and sell the news). To be clear, the Fed’s tapering announcement does nothing to reduce its $4 trillion balance sheet, but it does slow the rate of growth of that balance sheet and it is a move in the right direction toward shrinking it. We expect the dollar to stabilize versus the Pound and Euro and to continue to strengthen versus the Japanese Yen.
The three biggest influences on natural resource prices are: growth in demand from the emerging markets, the value of the US Dollar, and the rate of inflation. Specifically, strong growth in the emerging markets, a weak US Dollar and rising inflation would all be good for natural resource prices. Unfortunately, as noted above we see the dollar stabilizing and/or improving versus most major currencies; we see very few signs of inflation; and, we see emerging markets stemming their rate of slowdown in recent years but probably not quite poised to take off just yet.
Global Equity Markets
Emerging market economies slowed meaningfully in the past 2-3 years, but that decline appears to have bottomed. Not surprisingly, price-to-earnings multiples for emerging market stocks declined more than 10% over that same period. Any stability and/or improvement to earnings, which one would expect if their economic slowdown has indeed bottomed, would make emerging market stocks extremely attractive going forward. Developed international markets are more attractively valued than the domestic market, but we believe P/E multiple expansion will be more significant in the domestic market over the near-term. For the most part we are geographically neutral in our global stock allocations but are poised to increase our emerging market exposures should their recent trend of economic improvement persist. We continue to favor small- and mid-cap stocks over large cap stocks in most developed markets.
Global Bond Markets
The global bond market faces the same challenges as the domestic bond market: artificially low “real” interest rates, and historically low bond yields. Corporate debt in overseas markets has more upside than domestic corporate debt, as the yield spreads have not contracted as much; but, overseas balance sheets are not as transparent nor are they as clean as domestic balance sheets. In addition, an improving US Dollar would not bode well for the total returns of international bonds versus domestic bonds.
The domestic stock market closed the year with a strong finishing kick. The S&P 500 returned 10.5% in the fourth quarter to push the calendar year return to 32.4%. All other asset classes struggled to keep pace with domestic large-cap stocks; but, most equity asset classes posted solid returns for the quarter as the MSCI All-Country Stock Index returned 7.4%. The losers for the quarter, and the year, were bonds (with the exception of high yield taxable bonds). US Treasury bonds were the hardest hit taxable bond sector—down 0.9% for the quarter and 3.2% for the year. Investment grade municipal bonds returned 0.4% for the quarter, but the calendar year return was a negative 2.9%. The biggest loser for the year was the high yield municipal bond market—down 6.2% due to the uncertain implications of the Detroit bankruptcy.
The government shutdown in October put some downward pressure on stock prices early in the quarter, but after that initial dip it was pretty much straight up for the balance of the quarter. Even the Federal Reserve’s announcement in December that it would begin tapering its bond buying activities didn’t deter stock investors. As noted above, it was a much different experience for bond investors. 2013 was the worst year for investment grade bond investors in two decades; and, it was only the fourth calendar year in the past forty years in which the bond market posted negative returns. Interestingly, this past year was the first time the bond market posted negative returns in an environment in which the Fed wasn’t pursuing a tight monetary policy. The Fed’s balance sheet now stands at $4 trillion—about 5 times larger than it ever was prior to the financial crisis—one has to wonder what happens to bond returns should the Fed actually attempt to shrink that balance sheet to some level of normalcy.
All but the most conservative of our clients’ portfolios experienced strong absolute and relative returns. The growth (equity) sleeve provided the greatest absolute returns for the quarter. The non-traditional holdings (senior bank loans, preferred stocks, BDCs and distressed credit) in the income sleeve provided the most significant relative outperformance. As a group those holdings provided a positive 3% return in a period in which traditional fixed income holdings had a negative return.
Despite the run-up in equity prices in 2013, our outlook remains optimistic. Stock prices follow corporate earnings and we believe the corporate earnings environment remains positive. Recent economic data has all surprised to the upside; the bipartisan budget agreement removes an uncertainty; and, the Fed remains committed to anchoring short-term interest rates near zero percent for the next few years. We are approaching the fifth anniversary of this bull market—it is typically at this stage we expect to see price-to-earnings multiple expansion. P/E multiples for the domestic stock market are about 5% below their historic average—it is not uncommon, in the late stages of a bull market, for those multiples to expand well past their historic averages. We believe strong corporate earnings and price-to-earnings multiple expansion could generate another year of positive returns in the domestic equity market.
We remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.