2013 Annual Review and 2014 Outlook
- 2013 was a great year to be in equities, especially U.S. equities (30%+ returns).
- Returns were boosted when start-of-year worries did not end up mattering.
- The economy continued to strengthen over the year and continues in 2014.
- The Federal Reserve became more hawkish and began to plan its exit from quantitative easing, starting with a "taper" of long-term asset purchases.
- Fixed income and REITs suffered from the prospect of higher interest rates.
- High-dividend stocks and utility sector stocks also suffered.
- We expect the U.S. economy to continue to recover on growth and employment dimensions and perhaps even accelerate in 2014.
- Equity returns in 2014 are still likely positive, even if not as stellar as 2013.
- The Fed will be watching interest rate volatility as well as absolute rate levels as they manage their exit.
- Gradual mortgage rate increases may affect the pace of the housing recovery, but will probably not reverse it.
- An unexpected spike in interest rates is the major risk in 2014, but it is not part of our most-likely scenario.
- Europe appears to be stabilizing, but resumed growth is still uncertain.
- Emerging markets, especially China, still have substantial downside risks.
2013: A Great Year for Equities
Looking back, 2013 was clearly the year to be in equities, the best in nearly 15 years (since 1997, using S&P 500 returns). Not only did many equity indices deliver between 30% and 40% in total returns, few other asset classes produced anything remotely comparable. Looking at Figure 1, which shows 2013 total returns for several asset class and equity indices, it is clear that 2013 returns (for the assets shown) essentially break down into three categories:
- Developed market equities, which produced returns ranging from 20%-40%.
- Gold, which lost more than 25%.
- Everything else, which finished roughly flat on the year (including emerging market equities).
Figure 1 Source: Bloomberg, Russell Investments, MSCI.
Small cap equities produced the highest returns, at nearly 40%, whereas large cap and broad style indices delivered somewhat similar returns in the 32-34% range. Foreign developed markets were less spectacular but still produced 23% as represented by the MSCI EAFE Index, an admirable return for any ordinary year. The only major equity class to perform poorly in 2013 were emerging markets: the MSCI Emerging Markets index finished the year down by -5.0% before dividends and by -2.3% on total return basis.
Many Policy-Related Fears in 2013 Did Not Materialize
The U.S. faced a multitude of worries as 2013 opened: budget uncertainties, another approaching debt ceiling, an impending "sequestration" of budget cuts and tax increases, concern that the economic recovery was still "fragile," and that quantitative easing measures were losing effectiveness. At the same time, the 2012 elections had left the composition of Congress and the Presidency virtually unchanged, leading many to expect continued gridlock and brinksmanship on key fiscal issues.
The returns in 2013 were a classic example of stocks climbing a proverbial "wall of worry."
Tax increases went into effect in 2013 with the expiration of payroll tax relief and a reduction in earned income credits. The inability of Congress to agree on a budget plan triggered the fiscal "sequester" at the end of March, leading to tax increases and wide-ranging spending cuts, which many economists expected to create fiscal drag on the economy. More disturbing was the sense that such draconian measures had been erected in order to force agreement between Republicans and Democrats, and that even this threat of fiscal tightening was insufficient to create consensus.
In September, the Federal fiscal year ended without a budget agreement, effectively shutting down all but the most essential government services. Only weeks later, the debt ceiling would have to be renewed, or risk the U.S. defaulting on its Treasury obligations. Only in October did the parties finally tire of brinksmanship and enter agreements to resolve these issues. The government went back to work.
The Economy Strengthened in 2013, Despite Fears
What makes 2013 impressive is how the U.S. economy continued to power on, add jobs, and recover as if none of these issues mattered. Many economists and analysts expected to see the effects of tax increases and spending cuts show up as fiscal drag on GDP, and by extension corporate earnings, yet the private economy grew strongly enough that the effects of fiscal tightening and economic challenges abroad are almost unnoticeable.
The results show up in several areas: real GDP growth, steady employment growth, inflation under control, a recovery in residential real estate, and continued growth in corporate profits. Table 1 summarizes those trends since the 2008/9 financial crisis.
Table 1: Trends in Major Macroeconomic Indicators since 2008/9 Crisis
|CPI Inflation Rate||1.6%||1.6%||3.0%||1.7%||2.6%|
|Case Shiller Composite||13.5%2||8.1%||-3.9%||-3.0%||-0.6%|
|Corporate Profit Growth||4.0%3||2.8%||28.0%||-2.1%||54.1%|
|S&P 500 Total Return||32.4%4||16.0%||2.1%||15.1%||26.5%|
Source: Federal Reserve Economic Data (FRED), Bloomberg (for S&P 500 Total Return)
12013 GDP growth is trailing 12 months growth to 3rd quarter
22013 Case Shiller Composite is trailing 12 months increase to Dec 2013
3After tax corporate profits is for first two quarters of 2013 due to data lag
4For comparison to Corporate profits, 1st half 2013 S&P500 TR growth is 13.8%
These data demonstrate an economy continuing to strengthen, despite worries about fiscal paralysis and the change of tides in monetary policy.
Monetary Taper: The Fed's Inflection Point in Monetary Policy
After nearly five years of extraordinarily loose monetary policy, the U.S. recovery reached a point in 2013 prompting the Federal Reserve in April to discuss "tapering" its quantitative easing programs. In practice, "tapering" means that the Fed will reduce its purchases of long-term assets such as long-dated Treasurys and mortgage backed securities, thus letting long-term interest rates rise to rates determined more by private sector supply and demand.
With tapering, the Fed would still keep the fed funds rate (and by extension, short-term interest rates) low for the time being: the Fed's so-called zero interest rate policy (ZIRP) is distinct from quantitative easing, even if it serves a similar purpose. The Fed ultimately decided to delay tapering action until January 2014, but speculation about the taper's timing and effects dominated the latter half of 2013. The summer months and early autumn weathered increased volatility as investors tried to decide whether tapering would reduce the pace of economic growth and corporate profits, or whether it signaled improved strength and confidence in the economy. By the time the Fed committed to a January taper, markets absorbed the news smoothly and without skipping a beat.
The taper discussion had almost immediate effects on fixed income that lasted through the year, prompting many investors to sell bonds before the rate rise. Real Estate Investment Trusts (REITS) also suffered, since higher long-term and mortgage rates might dampen the recovery in real estate. Equities benefitted from these processes, since many investors preferred to reallocate their fixed income to equities, given the prospect of rising interest rates.
Continuing Consumer Balance Sheet Improvement
Over the course of the 2013, the improving economy, housing market, and employment figures, in combination with several years of active deleveraging, left consumers with improved balance sheets (as we discussed in more detail here.) The improved position created both greater ability and greater appetite to take on investment risk, creating the first year in many in which equities received a positive net flow of investment. This facilitated an environment in which price-to-earnings and price-to-book multiples could expand on top of general GDP and earnings improvement, and is one of the main reasons for the excellent performance of equities in 2013.
Healthcare, consumer services, industrials, were the leading sectors in 2013, whereas basic materials, natural resources, and utilities were the laggards. Financials and consumer goods performed roughly in-line with the market as a whole, and technology, energy, and telecom underperformed slightly.
Utilities emerged at the bottom in part because of where we are in the business cycle, and also because of their bond-like qualities. For much of the past four years, utilities and high-dividend stocks have been widely promoted as bond-substitutes: relatively low-volatility stocks that can produce dividend income at a time when bondholders are starved for yield. We are concerned that the unwind from this trade could be severe as bond yields creep up and other sectors of the stock market look healthier. The other lagging sectors – basic materials and natural resources – likely suffered due to the slowdown in China and other emerging markets.
Outlook for 2014: Continued Economic Strengthening
Looking to 2014, the big issues as we see them right now center on how the Fed's unwinding will take place and how the market and economy will react to it. Outside of the U.S., the larger questions revolve around whether and to what extent Europe is finally recovering from its recession, and on the performance of emerging markets. In emerging markets we are concerned about how severe China's slowdown will be and whether anyone's dirty laundry will be uncovered by it.
We expect the U.S. economy to continue to recover on growth and employment dimensions and perhaps even accelerate in 2014. Real GDP growth could perhaps come in as high as 3.5%, and unemployment could very well go below 6.5% during 2014, possibly triggering the Fed to let short-term interest rates rise. We are on the optimistic side of the consensus here, but not unreasonably so.
We do not see any major catalysts threatening to reverse the U.S. economic recovery...
Currently, we do not see any major catalysts that threaten to reverse the economic recovery in the U.S., although there is some risk that an unexpected interest rate spike could have adverse effects on growth, revenues, and asset prices. We do think that the Fed will be watching events carefully as it manages its withdrawal from quantitative easing and (eventually) zero-interest rate policies. The Fed will clearly try to avoid as many unexpected "bumps" as it can.
As we have written in other letters, the Fed will most likely act on more than just absolute interest rate levels, but also interest rate volatility and the effects on other assets and the economy. The Fed's ultimate goal is not simply to restore short and long-term interest rates to more "normal" levels, but to get them there in a smooth way, without derailing the recoveries in growth and employment.
A healthy economy can and should be able to tolerate a return to more normal levels of interest rates...
It is important to remember that letting interest rates rise after an economic recovery is a standard element of monetary policy. In most cases, an economic recovery's forward momentum is strong enough to counter the effects of interest rate increases. The last financial crisis and recession were especially hard and required unusual measures to counter them, but the basic process is still the same. The fact that interest rates are expected to trend upwards over time does not automatically signal the end of the recovery. A healthy economy can and should be able to tolerate a return to more normal levels of interest rates.
In housing, affordability can rise faster than mortgage rates...
Much the same can be said of the housing market. In 2013, the housing market continued to rally, at rates comparable to a decade ago, and we expect this to continue, if perhaps at a more modest pace. Many analysts are concerned that higher long-term interest rates will cut short the rally in home prices, which has done much to improve consumer balance sheets and support lower risk aversion as well as higher price/earnings multiples in stocks.
Here it helps to remember that mortgage rates are only half of the story. If housing becomes more affordable due to improvements in employment and income, it will counteract the effect of higher mortgage rates on prices. We think that consensus arguments are overly emphasizing the effect of interest rates and forgetting about the affordability side of the equation. A gradual increase in mortgage rates may reduce the pace of the recovery, but it should not reverse it. A spike in mortgage rates is much more dangerous, but as we wrote earlier, the Fed will likely be guarding against that.
We see no reason that U.S. equity returns should not be positive in 2014...
Equity markets are more complex, since they tend to lead rather than follow the economy. Last year was an extraordinarily good year for equity investors, and those who are chasing returns and expecting similar results in 2014 will likely be disappointed. However, we see no reason that U.S. equity returns should not be positive in 2014, even if some stocks may have gotten ahead of themselves in 2013.
Some investors will undoubtedly want to take profits after a 30-40% up year like 2013, and investors who rebalance multi-asset class portfolios to fixed allocation ratios will be selling some equities and transferring that capital to other asset classes. Together, these processes could lead to a correction of 5-10% before equities resume an upward trend. This is simply part of the natural readjusting of markets. We do not – for the moment – see a catalyst for a larger drop (more than 10%), although we remain vigilant in case one does appear.
The heightened risk at this point is that gradually increasing interest rates could morph into an interest rate spike. A material, sustained increase in U.S. interest rates will likely have negative impacts across many asset classes and the U.S. economy, spilling over into global economic growth.
Since the financial crisis, retail bond mutual fund assets increased by about $1.2 trillion, with new U.S. treasury issuance totaling roughly $3 trillion for the period. As the Fed tapers, a rush for the exits by retail investors fearing further principal losses has the potential to push rates higher. Bond mutual funds already registered $150 billion in net cash outflows in 2013, and produced negative returns for the year.
Expensive, high-beta, high-growth stocks can be vulnerable in this environment. High dividend yielding stocks which have been used – perhaps overused – as bond-substitutes during the recent yield-drought in fixed income could also come under pressure.
Equities in 2014 will probably not repeat the 30-40% banner year they had in 2013, but the economy continues to strengthen, and there is no reason not to expect another positive—though less spectacular—year for stocks.