GUEST COMMENTARY: Outlook remains bullish after equities hit new highs in '13
The U.S. equity market had one of its best years ever last year, with the large cap S&P 500 index gaining 32.4 percent and handily outperforming all other asset classes; except for U.S. small stocks, which were up an astonishing 41.1 percent in 2013.
Improving but still sluggish economic growth (around 2 percent), an accommodative Federal Reserve and very low inflation (around 1.3 percent) provided a Goldilocks-like environment for equities; not too hot, not too cold, but just right.
The international developed markets posted solid gains with the EAFE index up 22.8 percent. The Nikkei index soared 59.3 percent in yen, but only 30.5 percent in dollars owing to a weakening currency. The STOXX 600 Index rose 27 percent in U.S. dollars to a five-year high as Europe emerged from a shallow recession.
Apart from developed country equities most other asset classes struggled.
Bonds of all sorts declined as interest rates rose. Treasuries were particularly hard hit; the 10-year Treasury lost 9.7 percent in price, but gained 1.9 percent in coupon income, for a total loss of 7.8 percent last year. The broad Barclays U.S. Aggregate bond index was down 2 percent, its first negative year since 1999 and only the third year of negative total returns since inception of the index in 1976. The Federal Reserve’s decision to “taper” its monthly QE bond-buying program was the culprit here.
That tapering hurt emerging market stocks as rising interest rates in the U.S. provided stiff competition and flows reversed out of these developing markets. Stocks in these countries were down 2.6 percent for the year and have badly lagged the developed market equities over the past three years. What does that mean? They are cheap!
Commodities were hard hit especially precious metals. Gold dropped 28 percent to end the year at $1,202 an ounce. The energy revolution in the U.S. has suppressed oil prices (and created jobs and increased national security). The DJ-UBS commodity index lost 9.5 percent in 2013. That index has about one-third of its assets equally weighted in three sectors: energy, agriculture and metals. It provides a hedge against unexpected inflation, of which there was none in 2013.
2014: Consensus overwhelmingly bullish
It’s all good. So say the Wall Street strategists. The beginnings of a synchronized global expansion and still low inflation worldwide provided a healthy backdrop for the equity markets. And mostly all central banks remain in an easing mode. Even the Federal Reserve which is “tapering” its bond purchases has provided “forward guidance” promising very low short term rates for several more years.
Inflation remains subdued across the globe. The IMF puts inflation at 1.2 percent in advanced economies and at 5.8 percent in the emerging world, but that has been coming down. Part of the reason is modest economic growth, still high unemployment, and ongoing weakness in commodities that is expected to continue.
We are also seeing the results of globalization and improved productivity owing to technological change. Both help keep a lid on inflation.
In 2013, policy uncertainty reigned from fiscal cliff worries early in the year, to the sequester and finally a brief government shutdown and more brinkmanship over the debt ceiling. But by year end a two-year budget deal diminished the likelihood of another shut down for a few years, although a debt ceiling debate looms in the first quarter. The federal budget deficit has fallen much faster than expected. Relative to the size of economy it is now manageable in the short term.
Still, regulatory uncertainty and Obamacare anxieties linger among consumers and businesses. But measures of confidence have improved of late. The “wealth effect” from soaring stocks and home price appreciation has helped.
The one worry in an otherwise sunny U.S. economic outlook is prospects for rising interest rates. Fortunately we end the year with much of this already “priced in” to the bond markets. The yield curve is very steep with short term rates stuck close to zero and the 10-year Treasury yielding 3 percent, a two-year high.
The rest of the developed world is slowly digging out of the deficit/debt/unemployment mess left over from the Panic of 2008 and Great Recession. They are behind the U.S. in that regard. While the existential threat to the Eurozone has dissipated, euro integration is like herding cats.
Fiscal austerity, ECB actions, and prospects for a banking union have all helped, but it’s going to be difficult for several more years. Meanwhile, Japan’s three arrows of monetary ease, fiscal stimulus and structural reform (dubbed “Abenomics”) have stimulated the stock market and boosted inflation, but it remains to be seen if that economy can sustain momentum.
The emerging markets are a bit of a conundrum. While their demographics and fiscal positions are much better than developed markets, they have performed poorly. China in particular has seen growth slow from 10 percent to 7 percent and concerns about too much debt in the economy have surfaced. Most analysts believe China will land softly.
The Shanghai stock index was down 4 percent in 2013 – the year of the snake. Perhaps it will gallop in 2014, the year of the horse? Emerging markets in general remain a wild card in the outlook.
Valuation reflects optimism
Since the March lows of 2009, U.S. stocks have surged ahead by an annual rate of 25.9 percent. These gains have vastly outstripped growth in GDP and corporate profits. Now we were coming from the depths of recession so a snap back isn’t unusual, but at this juncture the equity markets are “pricing in” continued good news.
This question of “valuation” is one we spend much time on. It’s not enough to get the general macro trends right, the real question is how much is priced into the markets already? In fact the connection between economic growth and stock prices over the short term is fairly loose.
When it comes to stocks it’s important to remember that while earnings matter, what you pay for earnings is particularly important. The P/E ratio for S&P 500 stocks is 16x forward earnings which is a pretty full valuation. Much of the rally last year was mainly P/E expansion (i.e. not earnings driven) and profit margins are at record highs.
Stocks are cheaper overseas. Especially so in the emerging markets which trade at a 10x P/E making them attractive on both an absolute and relative basis to other markets.
When it comes to bonds, valuation is usually judged versus inflation. “Real yields” (nominal yields less inflation) have improved of late as interest rates have risen and inflation has dropped. At around 1.7 percent, the real yield on 10-year Treasuries is still somewhat low by historical standards. But in the context of a balanced portfolio, old fashioned bonds act as ballast and make more sense now than earlier in the year.
Portfolio strategy: Putting it all together
This year U.S. stocks were on fire having the best year since 1997, but most other asset classes performed only so-so. It’s possible we will continue to see a “melt up” in U.S. equities. Indeed the market may “party like its 1999.” But remember what happened after the dotcom boom post 1999. Stock performance was dreadful.
We still like stocks and have good allocations in our portfolios, but we are no longer “overweight” U.S. equities in a meaningful way. Rather we have been adding slightly to the overseas markets and are maintaining cash as a liquidity reserve.
Bond maturities are generally shorter than normal in most portfolios in recognition of rising rates. Commodities and international bonds have been an underweight for some time.
Readers know we recommend diversified portfolios and use 11 different asset classes to get exposure to stock, bond, and related markets around the world. We use low cost index funds, trade infrequently, and keep transactions costs down. We are convinced, owing to experience and hard-nosed research that this approach is in investor’s best interests.
We wish everyone good tidings and prosperity in the coming year. Many happy returns in 2014!
Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $2.4 billion investment management and advisory firm located Anchorage.