Focus on Equities: Fourth Quarter 2013 Review
An excellent quarter in an excellent year for equities
The fourth quarter of 2013 was excellent for equities, with large-capitalization U.S. stock indices producing roughly 10% in total investment returns. Small-capitalization indices produced slightly less, just under 9%, and growth stocks outperformed value stocks by about 0.3%. Non-U.S. equity indices did not fare as well as U.S.-based ones, but still performed admirably. Foreign developed stock markets (e.g. MSCI's EAFE index) produced close to 6% in total return. Even emerging markets—which had spent much of the year in a downtrend—rewarded investors with modest, but still positive returns for the quarter. Figure 1, below, compares the performance of major indices and provides more precise figures.
Source: Standard & Poor's, Russell Investments, MSCI
Positive results in Q4 were driven by several factors, centering on continued U.S. economic recovery and growing investor confidence, thus creating an environment conducive to earnings expansion. These explain, in part, why U.S. equities shined so strongly in comparison to foreign developed and emerging markets. These drivers include:
- Improving U.S. employment data (unemployment at 7%; lowest since 2008).
- Improving GDP growth (4.1% annualized Q2 to Q3 growth).
- Continued low inflation (stable at 1.7% annualized core CPI).
- Improved housing markets (prices up 13.25% year-on-year; sales up).
- Improved consumer balance sheets (See: Improving Consumer Balance Sheet Health is Key to Market Recovery).
- Resolution of budget and debt ceiling agreements for another six to 12 months.
- Fed commitment to a January start on tapering of Quantitative Easing.
The U.S. economy has powered out of the post-financial crisis recession and is moving forward to new ground.
Taken together, these data show that the U.S. economy has powered out of the post-financial crisis recession and is moving forward on to new ground. The recovery may still feel "sluggish" because the unemployment figure—while down from the highs of the recession—is still running higher than in previous expansions. From the perspective of equity investors, however, higher unemployment will keep downward pressure on wages and most likely strengthen the hands of shareholders in keeping profit margins high.
The Fed's decision to begin tapering its Quantitative Easing programs in January has analysts divided on whether interest rate rises will dampen the economic recovery and create downward pressure on stocks, or whether it will instill confidence that the Fed is being responsible and bring in more investors. We think that the Fed will be particularly careful not to derail economic expansion, especially as long as inflation remains low, and it will do so by carefully telegraphing its position and plans as they evolve.
In our view, it is very likely that the economic recovery has the power and momentum to offset the possible effects of rising interest rates.
Moreover, the signal that the Fed is serious about normalizing interest rates should improve investor confidence, both about the condition of the economy, and by reassuring those who have been worried about inflationary risk of an eternal Quantitative Easing. It is true that interest-rate creep could have negative impacts on stocks—and we have said before that high-dividend stocks are particularly vulnerable here—but in our view, it is very likely that the economic recovery has the power and momentum to offset the possible effects of rising interest rates.
Tapering is more likely to be felt in other asset classes, particularly in fixed income, where diminishing the Fed's role as a buyer of long-term assets will have a direct effect on bond prices. We suspect many investors will interpret the environment as unfavorable for traditional fixed income assets. They may well find equities more attractive, and increase allocations, hence driving equity prices higher.
We are likely still in early stages of price/earnings and price/book multiple expansion.
As we have mentioned elsewhere, the ongoing recovery in housing has improved the consumer balance sheet, and made consumers more willing to accept equity risks. Investor sentiment has improved substantially, suggesting that we are likely still in early stages of price/earnings and price/book multiple expansion.
Source: Standard & Poor's, Yahoo Finance (ETFs referenced: IYM, IYK, IYC, IYE, IYF, IYH, IYJ, IGE, IYW, IYZ, IDU).
Looking at sector performance, technology, industrials, and consumer services were the top-performing sectors in the fourth quarter while utilities, natural resources, and energy sectors lagged. For the 2013 calendar year, healthcare, consumer services, and industrials similarly led the way while utilities, natural resources, and basic materials trailed. As we previously noted (Focus on Equities for September 2013), sectors that typically score lower on ESG factors, e.g. energy, materials, and industrials, may reverse their trend of underperformance if the economic recovery accelerates.
If and when this happens, it may usher in a brief period during which SRI returns temporarily lag non-SRI returns. This possible reversal has not yet happened in any significant way, although industrials did prove to be one of the top performing sectors in 2013, and sales in the auto sector have improved markedly both in the U.S. and in several key emerging markets such as China and Mexico. We believe, however, that a temporary change in market leadership towards companies that score lower on ESG factors is an increasingly likely scenario as the new year progresses.
We expect the U.S. economic recovery to continue to gain strength into 2014 and to provide a firm foundation for continued improvements in growth and employment, even in the face of the Federal Reserve's tapering activities. It is important to remember that the Fed's taper is merely an inflection point in its provision of extraordinary post-crisis support. The Fed still provides levels of support far above and beyond historical norms; it merely has switched from expanding to reducing that level gradually over time. Moreover, should the withdrawal of Fed support unexpectedly push the economy back into recession, there is no reason to think the Fed would not slow or even reverse its decisions, unless inflation becomes a serious problem.
A bigger question is whether equity valuations already reflect current growth expectations, or whether there is room for continued price/earnings multiple expansion in 2014. Near-30% returns in 2013 already include a substantial component of multiple expansion, and so it is possible that financial markets may need to rest a bit in order to digest that expansion before moving any higher. However, we do think that improvements in the consumer balance sheet and employment, in combination with likely continued headwinds in fixed income, mean that more people will be ready to put investment money to work, and especially into equities. In this environment, it seems reasonable to expect continued multiple expansion in 2014, even if at a slower rate than was observed in 2013.
This commentary represents the opinions of the author as of 1/14/14 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
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