As we enter the second half of 2014, we have a more tempered outlook on our market return assumptions. We feel volatility will increase as the Federal Reserve transitions from a provider of liquidity to a retractor of liquidity by ending their quantitative easing program and ultimately raising interest rates in 2015. While this may sound counterintuitive, we believe the economy will continue to improve. Although volatility and the risks of corrections have increased, we feel a highly diversified portfolio will continue to significantly outperform cash over the next several years.
In 2014, U.S economic growth faced an uneven start. The weakness was attributed to one of the worst winters in decades, low capital spending by corporations, reduced government outlays and depressed consumer activity. Fortunately, as we anticipated earlier this year, each of these trends has begun to improve, which should benefit economic growth for the remainder of the year.
Domestic Economy Shows Signs of Strength
Corporations are reaching higher levels of capacity utilization and employment, both of which should increase investment spending. As a result, we have seen a dramatic uptick in merger and acquisition activity.
Thanks to a boom in domestic energy production, our country has become more energy independent and imported goods have slowed. This reduction in imported goods should help lift domestic economic output.
With the federal budget deal in place, another fiscal cliff or similar Washington slowdown appears unlikely. In 2013, falling government spending was a significant drag on our economy, but this challenge is largely behind us in 2014.
Unemployment Falls and Consumer Spending Increases; Housing Market Temporarily Slows
In more good news, the unemployment rate has fallen faster than the Federal Reserve anticipated and is now within one percent of their long-run target for full employment. Part of this fall can be attributed to decreasing labor force participation, but job creation has been the main driver. Approximately 8.8 million jobs were lost in the 2008 downturn, while 9.4 million have been created in the recovery. These jobs will continue to help drive the economy through consumer spending.
On the subject of consumer spending, U.S. consumers have reached new records of household net worth which provides fuel for consumption. In addition, low interest rates have provided an opportune time to lock in fixed rate financing—another key that could help propel spending for years to come.
The June housing starts report showed a 9.3 percent drop month-over-month to 893,000, while building permits fell to 963,000. Although this was a disappointment, we predict the trend will reverse itself thanks to low home inventories and mortgage rates. In addition, home construction and purchases that were delayed due to weather in the first quarter will likely occur later in the year.
Quantitative Easing (QE) Program Nears End
The Federal Reserve has stated they will stop their controversial quantitative easing (QE) program by ending the bond purchase program later this year. This should put upward pressure on interest rates, but the trend could be slower than most anticipate as the Fed continues to reinvest their current portfolio while bonds mature. The Fed has indicated that they will begin to increase the overnight lending rate approximately six months after the end of the QE program, which would be sometime between the first and second quarter of 2015.
Critics have suggested that the Fed’s QE program has fueled the market rally over the past several years. We agree that some of our recovery was due to increased liquidity, but perhaps more significantly, strong earnings have been the most important factor. Even during the first quarter of 2014, which had one of the worst economic growth rates since the recovery began, profits rose six percent year-over-year. With the second quarter earnings season under way, 76 percent of those companies that have posted results have beat their analysts’ forecasts for earnings and 67 percent have exceeded their sales forecasts, according to data compiled by Bloomberg.
Valuations Invite Tempered Expectations
Although the U.S. economy seems likely to slowly improve in 2014, it is difficult to get excited about valuations of marketable securities. Whether you use the price earnings multiple or any other valuation metric, the markets in general are clearly not as cheap as they once were. That said, they do not appear to be particularly expensive either. Given current valuations, investors should temper their expectations for meaningful returns in the U.S markets over the next 12 to 24 months.
Global Economic Health Warrants Cautious Optimism
Looking overseas, emerging markets remain attractive long-term investment opportunities, but there are some short-term concerns. Long-term growth is driven by growth in the labor market and increased efficiency. With a young workforce, high levels of investment, and lower debt loads, the emerging markets remain attractive in each of these areas. In addition, valuations of emerging market stocks are more favorable than in the majority of the developed world.
European equities look very attractive relative to the Unites States. Europe had a double-dip recession and, as a result, has had a much slower recovery. The unemployment rate in Europe recently peaked at 12 percent, which is a lagging indicator of economic growth. Earnings in the United States are 18 percent higher than the peak of 2007, while European earnings are 25 percent lower. The eurozone is in the early innings of economic expansion relative to the United States. As a result, the equities have greater potential to outperform. Therefore, we have reduced our United States equity exposure in favor of Europe.
Conclusion: Economic Fundamentals are Slowly Improving, Return Expectations are Moderating
The probability of a bear market still seems remote, barring an economic shock from a geopolitical or other unexpected event. Bear markets typically emerge from tight liquidity, deteriorating fundamentals and investors’ extreme euphoria, none of which are present today. Although we are entering into an era in which the Fed will be reversing course and could potentially raise rates in 2015, there are no signs of significant tightening of liquidity. Instead, there are now signs that private sector credit growth could start to replace the Fed as a supplier of liquidity. Economic fundamentals seem to be slowly improving and we do not see signs of extreme euphoria in the investment community as many people remain nervous.
Still, market volatility is likely to increase and total returns are likely to fall as equity valuations rise and the Fed adopts less-accommodative policies. On average, market corrections of 10 percent happen every year and we have not experienced a decline of this magnitude since 2012. Investors should stay focused on long-term market fundamentals and broadly diversifying their portfolios.