By: Trevor Callan
Last week was another down week for Wall Street which led the U.S. stock market to its largest monthly loss in more than a year. After five straight years of stock market gains, many observers question whether the climb can continue in 2014. With the 2008 credit crisis still fresh in investors’ minds, skepticism has been further fueled by concerns over China and other emerging markets. We predict, however, that market corrections and the growth of the global economy will create opportunities for investors during 2014.
While no market is without areas of concern, we remain optimistic about U.S. economic prospects for the upcoming year, though rises may be less dramatic when compared with the record gains of the past year. After the recent run in prices, a correction in the equities markets is healthy and should be viewed as an opportunity to rebalance portfolios. We expect the major trends during 2014 to be very similar to those of 2013, with one exception: lower returns. Analysis of current market dynamics suggests that 2014 will be a year of continued global growth, higher stock prices, and generally lower bond prices as interest rates slowly rise. Global economic growth is expected to accelerate in the coming year, driven by accommodative central bank policies abroad and a reduction in the pace of austerity both at home and in markets throughout the world.
In the U.S., several indicators point to faster economic growth in 2014. Sales of housing and cars are climbing, and companies are increasing capital expenditures and hiring workers to meet increased demand. The average net worth per capita broke records in 2013, and housing affordability is at historic lows, which fuels spending. Given these positive signals, we believe 2014 will be very similar to 2013, favoring equities at the detriment of fixed income securities. Interest rates should slowly drift higher, and we will most likely experience higher corporate profits. Inflation should remain relatively low, though higher than in 2013. During the past year, valuation expansion drove abnormally high returns in riskier asset classes, including stocks and lower quality bonds, at the expense of high quality bonds and cash reserves. Over the next five years, we believe the days of valuation expansion are largely behind us, and equity returns will be driven by earnings growth resulting in much lower returns, likely less than 10 percent. Of the 251 S&P 500 companies that have reported fourth quarter results, 74 percent have beaten earnings expectations and 67 percent have beaten revenue expectations. After the weaker-than-expected December jobs report, the Federal Reserve cited “growing underlying strength in the broader economy.” Then, as expected, the central bank announced another $10 billion per month cut in its asset purchase program. We believe the Federal Reserve will continue to taper and ultimately end the controversial quantitative easing program, which will result in higher yields placing pressure on high-quality bonds. As a result, we will continue our strategy of holding short-maturity, high-quality bonds with some exposure to below-investment-grade bonds.
There is also good news for European and emerging markets. Experts predict that Europe, which is showing signs of a recovery, will emerge into a growth cycle for the first time since 2011. Equity valuations are still attractive and look similar to U.S. equities one year ago. The manufacturing index has shown Europe emerging from a recession, and their recovery is only just beginning. The European Central Bank will most likely continue to provide liquidity as the Federal Reserve in the U.S. slowly withdraws liquidity from the system. As confidence builds in Europe’s recovery, we expect to see valuations rise, making European equities attractive over the next three to five years. As a result, we are increasing our exposure to international equities and more specifically, European equities, in 2014.
In Japan, the world’s third largest economy, Prime Minister Shinzō Abe has long campaigned to end deflation and revive the country. The prime minister’s policies have led to a falling yen, rising earnings, and rising asset prices. These trends should continue over the short term but longer term risks remain over their enormous accumulated deficit.
Emerging markets should continue to grow as well, albeit at a slower pace than in 2013. Emerging markets are expected to shake off their 2013 slowdown and grow by 5.3 percent per year over the next two years. In the short term, emerging market equities will likely struggle due to weak governance and volatility associated with the U.S. continuing to taper, but they offer reasonable valuations for investors with a longer-term outlook. Chinese GDP growth slowed to 7.7 percent in the fourth quarter of 2013. Meanwhile, purchasing managers’ indexes for the country indicated that the fourth quarter slowdown may have extended into 2014, as Chinese manufacturing activity contracted during January. Risks remain as emerging markets are vulnerable to a major dollar upswing and falling commodity prices.
In general, we favor the same asset classes that showed strength in 2013: equities; high yield bonds; and real estate. Equities should benefit from faster global economic growth, low inflation, accommodative central banks, and low but rising interest rates across the globe. We expect this year’s correction to provide an opportunity for investors to rebalance their portfolios into the asset classes that performed well in 2013. Although we expect the economic trends of 2013 to continue in 2014, we expect much lower average returns, as the valuations have increased dramatically. Overall, a growing global economy and healthy market corrections will create an opportunity, not an obstacle, for investors this year.