As we start 2014, we’re in a different economic and investment world than the one we faced entering the fourth quarter of last year.
The latest economic reports are much improved, and that is changing the view of what is going to happen in the year ahead. As recently as last fall the consensus was for U.S. Gross Domestic Product (GDP) growth of 2-2.5% for 2014. That’s long gone now, as economists have upgraded their forecasts and are now looking for growth of 3%-or more-for the year.
The economy is turning the corner and now has momentum. But a lot of this economic improvement has been discounted by the markets already. So what does that mean for the markets and our portfolios? Clearly, we must temper our expectations coming off a year like 2013. Our view is that we will see more volatile markets in 2014, featuring bouts of profit taking and “higher interest rate” selling. Despite the markets’ long run up last year, we still see opportunity for solid gains in 2014. That would mean 10-12% for the U.S. markets (that is above most current forecasts) and about the same for Europe. Fixed income returns will be hampered by higher interest rates; finding yields that are not negated by price declines will be a challenge.
Here at home
A Christmas Eve article in Moody’s Analytics by Ryan Sweet entitled “U.S. Economy Finding Its Rhythm” sets the tone for our domestic analysis. In it, Sweet says, “The U.S. economy is breaking out of its rut. Given new data on durable goods and new home sales, our high-frequency model estimates fourth quarter GDP growth of 3.6%, up from 3.4% Monday and 2.6% last week.” Yes, a one percent increase in projected annual GDP in one week may seem a little aggressive, but you get the point. The U.S. economy is starting to take off.
Let’s take a look as some of the numbers that are behind this view:
On December 31, the Conference Board released its consumer confidence index, which showed an increase in December to 78.1 from 72 in November. That jump put the index close to its pre-government shutdown level.
Also released on the 31st was the S&P/Case-Shiller real estate index which showed property prices in 20 cities climbing by 13.6% in October (year over year), the largest gain in more than seven years.
As mentioned above, orders for durable goods exceeded expectations in November, rising 3.5% after a 0.7% drop in October. The median estimate had called for a 2% increase.
In another Christmas-eve release, purchases of new U.S. homes were above projections, holding near a five-year high. The sales number, along with firm prices, demonstrates that recent momentum in the real estate market continues even as mortgage rates have climbed.
Third Quarter GDP was revised up to 4.1%, the best quarter since the end of 2011.
The increase in durable goods orders confirmed other reports showing increasing confidence in the manufacturing sector. The Institute for Supply Management ISM) reading on factory activity has advanced for six months in a row, and in November it reached a two year high.
Manufacturing is adding fuel to the expansion right now, and we expect the sector will continue to grow in 2014 as investment spending finally comes through. Strong U.S. manufacturing is good news for overseas markets, including Europe, China and Japan. European manufacturing and services firms, in particular, should do very well if U.S. manufacturing stays strong. We see the same growth from Europe as that of the U.S. in a bull market.
Remember the Fed?
With all the upbeat economic news, the Fed’s tapering announcement had little effect on the markets. In an example of a “good news is bad news” scenario, the recent string of positive economic reports could make things tough on Janet Yellen as she takes over as Chairperson of the Federal Reserve. Although the Fed intends to taper its bond-buying from $85 billion to $75 billion per month, there are voices calling for a more substantial change in policy. Count Deutsche Bank chief U.S.economist Joe LaVorgna in that camp. “With growth (in 2014) to the mid-3s and potentially higher, you’re actually adding accommodation to the economy. Yes, you’re slowing the pace of the buying, but the balance sheet is still growing. It’s staggering to me. I just don’t see how they’re going to get out in a clean way,” said LaVorgna.
Yellen apparently doesn’t share the view that a financial bubble is fait-accompli. She has been somewhat skeptical of the strength of the economy’s recovery, particularly with regard to the drop in the unemployment rate vis-à-vis the labor participation rate. She is expected to take a cautious tone to start her term, and figures to keep the tapering to $10 billion until at least April. She will likely communicate her desire for the Fed to remain flexible in case growth slows.
In terms of our recommendations and results, the Yellen Fed should continue to be a positive for equity prices. Since it became clear in the fall that she was the likely successor to Ben Bernanke, she has had a hand in policy making. She is likely to (largely) preserve her predecessor’s strategy of stimulus and low rates for at least the early portion of her tenure.
What does it all mean for the U.S. markets?
2014 will not be a steady path to a 30% gain like the year gone by. We believe the new year will be “choppy,” particularly in the middle quarters. After a relatively strong First Quarter, in terms of economic growth and equity returns, the middle quarters will be vulnerable. Remember, as the year goes on tapering will be taking place, with interest rates moving up slowly. Every now and then we expect to see both profit taking and “higher rates” selling.
In terms of valuations, the S&P 500 is sitting at about 16.5 times forward earnings. In our view, that is approaching fully-valued territory. We don’t expect the multiple to increase by much in 2014, so any price gains will have to come as a result of earnings growth. The good news is bottom-up estimates of 2014 S&P earnings growth is 13%. Although our bullishness is hemmed-in somewhat by valuations, the earnings growth likely to come out of the strengthening economy should lead to a 10-12% gain in U.S. stocks in 2014.
Domestic stocks are still the place to be.
Europe has come a long way in three years. The euro bloc was in shambles in 2010-2011 as huge public debts threatened to break the region apart. The Euro Stoxx 50 Index declined by 35% between February and September 2011 as government bond yields went above 6% in Italy and Spain. Equity markets were volatile throughout the area.
Enter European Central Bank President Mario Draghi, who promised in the summer of 2012 to do whatever was needed to defend the euro. Markets have since stabilized, and advanced. Although European stocks are no longer dirt cheap, the threat of economic Armageddon is gone and the future looks much brighter. We see 10-12% out of the eurozone in 2014 as well.
Japan is coming off a fantastic year for stocks as the Nikkei 225 advanced almost twice as much as the S&P 500 (57% to 29%, not including dividends). A weaker Yen has contributed significantly to increased exports, and the government introduced a stimulus package in early December. The goal is to improve growth, which was at about 4% in the first half of 2013 and 3% in the second half. One interesting measure is that Japanese stocks are about 40% cheaper than U.S. stocks based on book value.
GDP growth in China is expected to soften to 7.4% in 2014. This is after an (expected final) rate of 7.6% for 2013, the weakest in 14 years. This is not as bad as it may seem, however, as new policies coming out of the Third Plenum meeting in November are geared to create a healthier, consumer-driven economy which promotes internal and external demand. Wages are expected to increase about 10% next year, which should boost consumption.
There are three positive factors for Chinese stocks:
The country’s growth rate is stabilizing, which is necessary coming off decades of following a pro-growth model.
The economic reforms coming out of the Third Plenum meeting look serious.
Equity prices are undervalued.
There are a lot of positive things happening as we go to press. Our risk-adjusted performance has been very satisfying of late, and it’s easy to be bullish at this time. But we are not fully invested in equities, and that is in line with the outlook. There may be some fine-tuning necessary, as we will likely examine further diversification as the year unfolds. Overall, though, our portfolios are in excellent shape as we enter 2014.
But it is wise to offer some words of caution as we enter the new year. Valuations are a concern, and they are certain to contain our bullishness for 2014. The P/E for the S&P 500 grew from 13.5 to 16.7 in 2013; historically, the ratio is 14.5. Gains will have to come from earnings growth, not a higher multiple.
You should curb your expectations for stocks. It is hard after a +30% year, but this is precisely the time to be realistic. Watch out for the so-called “melt-up” as investors try to play catch-up after 2013 and rush into the market. That could push the market higher, but increase the risk of a bubble.
The outlook for most bonds in 2014 is not good, so be selective. The Barclay’s Aggregate Bond Index was -2% for 2013, and rates are very likely to rise slowly in 2014. The floating rate and shorter-maturity funds are the best fixed-income alternatives.
Our conclusion is that a balanced portfolio is the best formula for 2014. That may lead us to trade domestic positions for stakes in Europe and/or Asia. We must remain disciplined, as the markets (especially here in the U.S.) could be frothy early. Diversification is a must for 2014… as we turn the corner.