Vigilare Wealth Management Outlook and Strategy for 2014
2013 was a whopper of a year for U.S. stocks. The same could not be said of other investments such as bond investments which had their worst year since 1994. A conventional conservative allocation was left in the dust by their more aggressive counterparts. In reality any investment allocation outside of the U.S. stock market (except Japan) lagged.
Looking back on our baseline scenario assumptions at the beginning of last year, we felt that after consecutive years of fits and starts in the economy, that 2013 could be the year in which Fed monetary policy combined with the beginnings of a sustainable economic recovery would change the pattern which had plagued the economy over the prior couple years, and the Fed would finally begin to achieve its goal of reflating the economy. We anticipated stock gains of 10-15% and bonds losses between 2.0-5.0% (refer to 2013 outlook).
Yet there were many uncertainties at the start of 2013 including ongoing fiscal uncertainty, unknown impact of new tax hikes/spending sequestration on economic growth, ongoing multi-year European recession struggles, and China slowdown (to name a few). Fourth quarter 2012 GDP registered a dismal 0.1% followed by a slightly better 1.1% in the first quarter of 2013. Our optimistic case for improving stock returns was based on reaching some political and tax certainty, and a continuation of at least a modest real estate recovery, with the backing of clear Fed policy (to create inflation), which would lead to more confidence in consumer, business, and bank behavior. This renewed confidence would stimulate real economic growth and combined with very accommodating Fed policy could create a prolonged period of good returns for the equity markets.
Through the first half of the year the economic data was not very strong and fed communication was ambiguous (to taper or not to taper), and there was still the looming fiscal uncertainty Congress had yet to tackle. As the year progressed, the economic data improved and Congress finally reached a fiscal resolution. The Fed also improved its communication, correcting some of the missteps from earlier in the year. President Obama nominated Janet Yellen (and she was successfully confirmed) successor to Fed chairman Bernanke maintaining continuity (our assumption) in Fed policy. At the same time, China aggressively intervened in its financial markets when needed to maintain stability, and Europe slowly crept out of chronic recession.
U.S. company earnings grew about 6% in 2013, a modest improvement from 2012. What was then responsible for the big market returns? The bulk of returns in the markets came from paying a higher price for earnings (P/E expansion). The returns in the market were in lockstep with the Fed bond purchases (QE) throughout the year, even early in the year when the data was weaker. The trailing 12-month price to earnings (P/E) ratio for the S&P 500 increased 25% in 2013 by year end, while the Fed balance sheet swelled to over $4 trillion. U.S. stock funds had their first yearly net inflows since 2005, while U.S. bond funds had their first yearly net outflows since 2000. Interestingly, inflation as measured by CPI ended the year at 1%, hovering at the lowest levels dating back to 2009. This benign inflation, with economic improvement and rising rates was highly unusual. Given this backdrop, inflation oriented investments also performed very poorly in 2013.
Moving to 2014, here are some key global assumptions shared by the majority:
-Fed is in control and will continue to promote growth (since job and income growth are still below targets)
-Deflation is still more of a concern than inflation (globally)
-Europe is recovering and Eurozone breakup is off the table
-China financial and real estate markets are under control
-Japan Abenomics experiment is working so far
-Global growth forecasts are improving
2014 Strategy
Baseline Scenario: 75% likelihood
Our outlook for 2014 continues where our 2013 baseline scenario left off. 2014 will be the year in which broad based inflation returns. We anticipate a year in which the realization of an improving global economy along with expansionary monetary policies, will lead to better than expected upward revisions in GDP. Inflation expectations for the first time in years will begin to set in and move higher. This will be a surprise to most (remember U.S. CPI is at 1% and in Europe less than 1%). The implications for investments will depend on the speed at which inflation manifests itself and the balancing act of central bank policy makers in telegraphing their eventual exit strategies.
To be clear, we view this as a positive development for markets because growth accompanied with some inflation could alleviate some of the structural problems still lingering from the 2008 crisis. Our base case is for more of a 90s-type scenario, but watching interest rates and currency volatility would be the indicators that could debunk our more optimistic view.
In this environment we expect equities to outperform bonds, with an emphasis on cyclical stocks like financials, industrials, technology, and consumer stocks while reducing interest rate sensitive sectors stocks like utilities, telecom, and REITs (REITs may be OK with steady inflation). Commodities may also find some footing this year. Within the bond markets TIPs investments may be a positive surprise.
Alternative Scenario 1: 5% likelihood
The global economy relapses into a slowdown. Economic growth is improving, but still very close to a stall speed and fragile. Europe is eking out of recession and the U.S. has just recently begun to show signs of improvement. Lack of global inflation could be an indicator of an underlying weakness in global economy which gets exposed in 2014. This would be bad for equity markets because of the already expensive stock valuations and the disappointment in meeting those lofty growth expectations. This would also put the Fed in a difficult position as the effectiveness of its policies would be criticized and questioned. Because of the above average valuation of the stock market, there would probably be a bear market in stocks with losses in excess of 20%. Investors would flock to the safety of U.S. treasuries. There would likely be a catalyst and/or a change in leading data which would help us identify and manage this unlikely scenario.
Alternative Scenario 2: 20% likelihood
This scenario is not based on a single event, but on a number of possible surprises that could thwart our baseline scenario outcome. The first would be the possibility of the Fed losing control over inflation, discussed in our baseline case. The risk is if inflation expectations become overly volatile and/or if the world central banks mishandle the policy progression towards normalcy. For example, how would the Fed respond to CPI level of 3%? Would they still be committed to maintaining short term rates at zero? Would their credibility suffer? Theses policy decisions could lead to market behaviors observed in the mid-70s versus the mid-90s. Second, there is still the uncertainty as to how effectively the Fed will manage its exit strategy regarding QE and low rates in a stable environment. How will the market respond to “getting off” the monetary sugar high? As always, there are also unpredictable geo-political events that could flare up at a moment’s notice and change the trajectory of the global economy.
In Closing
We believe we are not in a bubble, but there are many bubble-like tendencies in the market: bull/bear sentiment at decade highs, very low rates and financing terms for junk bonds, margin debt levels pushing highs, stock buybacks pushing highs, many stock valuation measures well above average (like small cap stocks more expensive than in 2000), and corporate profit margins near all-time highs. In 2013, sentiment was a large driver of returns rather than fundamentals. Sentiment can be capricious and fickle. As global economies improve our view is that market returns will be more permanent, predictable, and sustaining.
In all, we expect 2014 to be a favorable year for stocks although with more volatility than last year. In fact, we believe economic growth may even keep pace or exceed market returns which would be a reversal from last year. We do not expect to see the same level of P/E expansion the market had last year and expect more “blue collar” type returns. This is a good and a healthy condition and if bond rates normalize it will be even better. We have been aligning portfolios with our baseline scenario and will continue to do so in 2014.