Chief Investment Strategist
Investors were rewarded in 2013 by taking an optimistic view on macro-oriented risks and being positioned for valuation expansion. We entered the year with an overweight tactical risk position, a view which became much more consensus-like as the year progressed. During the year, we adjusted our tactical recommendations to reflect the increasing prospects for normalization of Federal Reserve (Fed) policy, improving developed equity markets outside of the United States and increasing risks in the emerging markets. Global growth is gaining momentum as we move toward year-end and will likely benefit in 2014 from significantly reduced fiscal drag in economies such as the United States, the United Kingdom and Europe. Disinflationary trends in the developed economies have allowed central banks globally to continue ultra-easy monetary policy, which has been promoting risk taking in markets and, to a smaller extent, economic growth. We continue with a tactical overweight to risk into 2014, a year in which we expect economic growth to reaccelerate and support corporate earnings growth. Our primary risk case revolves around monetary policy and the Feds ability to manage the start of its interest rate normalization process, which began with the announcement of a reduction in monthly bond purchases and enhanced forward rate guidance.
EXHIBIT 1: STOCKS ARE LIGHTER THAN GOLD
Source: Northern Trust, Bloomberg. Data through 12/13/13.
We expect growth in the United States, Europe and Japan to modestly exceed investor expectations in 2014, but we remain concerned that emerging market growth will disappoint. While the Fed has begun to taper its bond purchases, we still think monetary policy will be broadly accommodative across the developed world as unemployment remains too high and disinflation is wide-spread. The election cycle in 2014 shifts the risk focus to emerging market countries, such as India and Indonesia, whereas the political power structure in the United States, China, Europe and Japan looks stable. Geopolitical risks also look to be shifting from the Middle East to Asia, with heightened tensions over the disputed air defense zone between China, Japan, South Korea and the United States. At this point, however, a change in the outlook for the extended period of easy global monetary policy remains the most likely reason for us to consider changing our overall risk appetite during 2014. We highlight our tactical views on the major asset classes in Exhibit 2.
EXHIBIT 2: 2014 OUTLOOK BY ASSET CLASS
*TAA = tactical asset allocation; SAA = strategic asset allocation. These recommendations, based on the Global Tactical Asset Allocation Model, do not include alternatives. We believe strategic holdings in both private equity and hedge funds can assist in increasing portfolio efficiency but, due to the nature of the investments, we do not make tactical recommendations.
GROWTH & INFLATION
Global growth and inflation have both surprised on the downside during the past three years but we dont believe 2014 will be a repeat of this disappointing performance. For one, we are exiting this year with improved momentum, with the global purchasing managers index rising above 54 (versus 50 a year ago). Additionally, several years of fiscal drag, induced by deficit-fighting governments (higher taxes, lower spending), may prove to be less of a headwind to growth in 2014. As shown in Exhibit 3, the International Monetary Fund (IMF) forecasts both the United States and the United Kingdom will have 1.7% less fiscal drag in 2014 than in 2013 (all else the same, economic growth would be 1.7% faster). The IMFs forecast for the European Union suggests 0.7% less fiscal drag, while Japan may actually see increased fiscal drag of 2.5%. We find this forecast unlikely, as it would be a major headwind to Japan Prime Minister Abes recovery plan, and wonder if the IMF has not fully accounted for stimulus planned to offset the impact of the planned value-added tax increase. While we dont assume that all of the reduced fiscal drag in the United States, the United Kingdom and Europe will flow through to economic growth, we do believe it diminishes this headwind considerably.
EXHIBIT 3: FISCAL DRAG WANING; INFLATION STILL TAME
Source: Northern Trust, DB Global Markets Research, IMF, Bloomberg; data through November 2013.
The most important influence on developed market inflationary trends over the last several years has been the deflationary impact of deleveraging and fiscal austerity. In economies with over-capacity, slack demand has led to a lack of pricing power and slowing rates of inflation (disinflation). We have never believed that central bank accommodation by itself was going to create inflation, as we have been in various degrees of a liquidity trap ever since the financial crisis ended. So what could cause inflation to ignite? The most likely candidates are either a jump in the money supply or a sudden increase in the bargaining power of labor. For the money supply to jump, we will need to see increased credit demand only likely in an environment where private demand for goods and services increases well beyond our expectations. On the bargaining power of labor, the pockets of strength seem limited to those economies with little spare capacity primarily in emerging markets. While important economies like Brazil and India are facing inflationary pressures, other large economies like China, South Korea and Taiwan have inflation below target levels. Overall, this leaves emerging markets with a relatively steady inflationary environment in 2014. In the developed markets, the only major market with upside risk to inflation in 2014 appears to be Japan, as this is actually an objective of both fiscal and monetary policy in that country.
Central bankers have historically been reticent to exercise their role as lender of last resort, so it is quite understandable that they have loathed their role as policy makers of last resort over the last five years. With developed country politicians locked in deficit reduction mode to combat ballooning debt levels, it has been left to monetary policy to try to reinvigorate growth and reduce unemployment. The ultra-easy monetary policy undertaken by the Fed has significantly benefited financial assets, but it has not generated the type of growth that the Fed Board of Governors expected. The Fed has cushioned todays announcement that it will begin tapering monthly bond purchases by $10 billion with commentary that will likely be appropriate to keep the federal funds rate at current levels well past the prior unemployment threshold of 6.5%, especially if inflation is below the 2% target. The Bank of Japan is undertaking an even more aggressive policy, but the European Central Bank has been more surgical in its policy initiatives. As these policies have greatly benefitted financial markets, the slowing and eventual unwind of these accommodative policies presents the central question to investing today. In the Fixed Income section of this commentary, we address the potential impact of reduced purchases on interest rates. With respect to policy interest rates (directly affecting short-term rates, indirectly affecting long-term rates), we do not expect much if any change over the next year across the major developed markets.
EXHIBIT 4: SEPARATE AIMS
Source: Northern Trust, Bloomberg; data through November 2013. Year-to-date (YTD) growth rates annualized.
Emerging market central banks are more heterogeneous and face different challenges than their developed market counterparts. Chinas policy makers have been slowing credit growth (as shown in Exhibit 4) to combat concerns over bad credit creation, while Brazil and India face greater growth and inflation problems. Adding to the mix the potential for capital outflows to developed markets as monetary policy begins normalization, the risk to interest rates in the emerging markets is to the upside. Inflation is below central bank targets in developed economies (as shown in Exhibit 3), while it is above target in important emerging markets like Brazil, India, Indonesia, Russia and Turkey. Overall, we believe emerging market monetary policy is likely to remain restrictive in 2014.
What drives interest rates? In thinking about the outlook for fixed income, much focus today is on the impact of reduced Fed bond purchases on Treasury and mortgage-backed security (MBS) interest rates. While some analysts focus on the percentage of issuance (the flow) being bought by the Fed, we think about the issue more holistically. For instance, while the Fed purchased 76% of the increase in federal debt over the past fiscal year, this represented only 5% of the overall outstanding amount (the stock) of publicly-held debt. Year-to-date, the Fed has purchased an amount equal to 208% of MBS flow, but this represents 10% of the MBS stock. No doubt, the continually expanding Fed balance sheet is beginning to add up the Fed now owns 17% of publicly-held Treasuries and 28% of the MBS market. However, we believe the Fed will likely hold these securities to maturity. As such, a key question about the future course of interest rates is whether the reduction in the Feds purchases will prove material in the face of the overall level of the stock ($16.8 trillion). We think the stock effect will overwhelm the flow effect, so Fed tapering of perhaps $10-$15 billion per month should be manageable when accompanied by enhanced forward guidance. However, considering how experimental this whole program has been, we would expect volatility to remain high with risks remaining about the successful execution of the wind-down.
EXHIBIT 5: STOCK, FLOW OR FUNDAMENTALS?
Source: Northern Trust, Barclays Capital; GDP data through 4Q2013 (estimate), 10-year U.S. Treasury (UST) yield as of 12/16/2013. *QE: Quantitative Easing.
Historically, interest rates have followed the path of nominal economic growth (see the right panel of Exhibit 5). In recent years, this relationship has deviated significantly a development partially attributable to Fed actions. However, it is also true that nominal growth remains modest and below longer-term averages. As such, we believe increases in rates from where they currently sit are likely more dependent on changing fundamentals (real growth and inflation), as they are on reduced monetary policy accommodation. Should growth remain slow but steady and inflation levels remain contained, the anchoring of the short-end of the yield curve should put some ceiling on the level of longer-term interest rates. Additionally, the markets appear more prepared for this than last year, as the 10-year U.S. Treasury yield is currently at 2.9% (versus 1.8% at the end of last year) and investment grade yields are currently at 3.1% (versus 2.6% at the end of last year). High yield bonds have bucked this trend, in the search for yield, and are currently yielding 5.7% versus 6.1% at the end of last year. While credit spreads have narrowed to relatively low levels in both investment-grade and high-yield bonds, we expect only modest widening over the next year as credit quality remains high. Credit quality has also improved in U.S. municipal bonds, and while volatility will remain high, we see relative value especially in longer maturities. From an overall portfolio construction viewpoint, we continue to view investment-grade bonds as excellent diversifiers and dependable sources of future liquidity. However, the still relatively low level of interest rates only provides some cushion against the risk of further rate increases.
There was little differentiation among equity returns in the different regions in 2012 as the rising tide lifted all boats. This year, risk-taking has favored developed economies over emerging markets. Strong U.S. equity outperformance has been driven mostly by multiple expansion, as the bull market that began in October 2011 continues its cycle. This is also reflective of corporate Americas focus on capital allocation during the period of uncertain economic growth since the financial crisis, corporate management teams have increasingly used their excess capital for dividend increases and share repurchases. The S&P 500 price-to-earnings ratio reached 17.0 at the end of November (surpassing the historic median of 16.4), but we dont find stocks expensive. Our base case forecast for 2014 is for U.S. earnings to grow at a rate of 6%, and for multiples to modestly expand as U.S. equities continue to be an asset class of choice for global investors.
EXHIBIT 6: ABNORMAL RETURNS
Source: Northern Trust, Bloomberg, MSCI; data through 12/13/2013.
In developed countries outside of the United States, earnings began to grow in 2013 after declining significantly in 2012. This reflects a significant rebound in Japan, but also an improving trend in Europe. We expect earnings growth of 9% in 2014, primarily driven by cyclical recovery in Europe, and a modest expansion in valuations. Emerging market returns have been very volatile in recent years, falling 18.2% in 2011 only to bounce back 18.7% in 2012 along with the other global markets. Emerging market stocks have been the worst-performing equity group this year, as earnings have modestly declined and multiples have contracted. We do expect improvement in 2014, as earnings should regain momentum along with the global economy we estimate growth of around 6%. As the monetary policy picture remains restrictive, we have assumed no change in valuations as investors await further interest rate clarity before bidding up valuations. Overall, we think the relative economic and monetary policy momentum in the developed markets should lead to continued outperformance over the emerging markets in 2014.
At this time of year, stock market forecasts are as common as holiday sales. We thought we would provide a little context for how hard single-year forecasts are highlighting how volatile the stock market tends to be. Using historical data for the S&P 500 as our proxy, we found annual total returns for U.S. equities over the past 87 years averaged 11.8%, with a standard deviation of 20%. Exhibit 7 details the frequency with which returns lie within different domains of 5% and shows the distribution exhibits very fat tails. Most strategists annual forecasts fall in a range of 10%-15%; however, the actual return has only fallen in that range 7% of time historically! In fact, since 2000, the average strategists estimates for calendar year total return for the S&P 500 is 10.7%, and has only been outside of the 5%-to-15% range four times (in 2000, 01, 03 and 05). In 28% of the instances, the market generated a loss and in another 26% of the time, it returned 25% or greater. If you are going to guess, go high or low!
EXHIBIT 7: IF YOURE GUESSING, GO HIGH OR LOW
Source: Northern Trust, Bloomberg; 87-year history through 2012. Red bar indicates where average falls.
Real assets are typically utilized to provide protection against unexpected inflation. However, 2013 has shown that other factors are also at play. Global real estate and global listed infrastructure (considered real assets because of their better ability to pass-through inflation to the end user through increased rents or utility prices, for instance) showed their interest rate sensitivity as real interest rates surged mid-year. Increases in real rates (rate increases not tied to accelerating inflation) represent the worst of both worlds for these asset classes as funding costs go up, but the lack of inflation results in little pricing power. Despite the mid-year volatility, global listed infrastructure appears set to still provide double-digit returns while global real estate took concerns over Fed tapering harder and looks to end the year flat. In the commodity space, an equity-based approach benefitted from its equity risk factor exposure and outperformed a futures-based approach by 4% (although both asset classes were negative in absolute terms). In the inflation-protected fixed income world, 2013 served as a reminder to inflation protection seekers to keep durations short to purify inflation exposure. For instance, as real rates rose over the past year between 1% and 1.5% across the duration spectrum, the longer-duration Barclays Capital TIPS index fell by 8%, while the shorter-duration Markit iBoxx 3-Year Target Duration index fell just under 2%.
EXHIBIT 8: REAL DISPERSION
Source: Northern Trust, Bloomberg; data through 12/13/2013.
Heading into 2014, we continue to be underweight real assets in aggregate, driven by underweights in global real estate and listed infrastructure and equal-weights everywhere else. We believe inflation is a longer-dated concern, and is also understood (and priced) by the markets reducing the near-term appeal of real assets. In addition, we are mindful of the impact of interest rate volatility on returns and this was a key reason for our reduced tactical allocation to real estate earlier this year. Within our risk asset exposures, we favor those assets that are less exposed to interest rate volatility (like equities) over the more interest rate sensitive asset classes.
Thanks to Joe Welsch, Investment Analyst, for data research.