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Investment Strategy Commentary

2014 Outlook: Less of a Drag

December 2014

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 a favorable risk position, a view which became much more consensus-like as the year progressed. During the year, we adjusted our views 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 gained momentum as we moved toward the end of 2013 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 to favor 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 Fed’s 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.

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Growth & Inflation
Global growth and inflation have both surprised on the downside during the past three years. But we don’t believe 2014 will be a repeat of this disappointing performance. For one, we exited 2013 with improved momentum, with the global purchasing manager’s index rising above 54 (versus 50 in 2012). 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. While we don’t 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. 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.

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Monetary policy
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  —  and can be seen in the expansion of central bank balance sheets over the past few years. 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. We do not expect much if any change over the next year across the major developed markets. Emerging market central banks are more heterogeneous and face different challenges than their developed market counterparts. China’s policy makers have been slowing credit growth to combat concerns over bad credit creation, while Brazil and India face greater growth and inflation problems. Inflation is below central bank targets in developed economies 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.

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Fixed Income
Historically, interest rates have followed the path of nominal economic growth. 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 was at 3.0% as of December 31, 2013 (versus 1.8% at the end of 2012). 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. 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. In 2013, risk-taking 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 America’s 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 don’t 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.

Real assets
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 negative outlook on real estate earlier in 2013. 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.

The perils of prognostication
To close, and to keep ourselves from getting too confident, 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%. Most strategists’ annual forecasts fall in a range of 10–15%; however, the actual return has only fallen in that range 7% of the 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 5–15% 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!

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