The last month of 2013 looked much like the year overall: U.S. stocks were strongly positive, and international developed markets also gained. At the other end of the spectrum, bonds declined as yields rose and emerging-markets stocks and bonds were generally negative. For the full year, the Vanguard 500 Index (our S&P 500 proxy) was up 32%—the index’s best showing since 1997—and small caps soared even higher, gaining 39%. In the year-end commentary that follows, we review the big-picture themes underlying these results, including U.S. (and global) monetary policy and U.S. (and, in some cases, global) economic improvement. Several of the year’s dominant macro trends were also front and center in December. Monetary policy—a major source of support for rising global stock markets in 2013—made news last month as the Federal Reserve announced its first actual reduction in its monthly bond buying. In contrast to May of 2013 when Fed Chairman Ben Bernanke began discussing a possible taper, investors took December’s announcement largely in stride. Another key theme for the year overall was U.S. economic improvement. Here, too, December continued the trend with positive data releases in areas such as employment and consumer confidence.
Developed international markets gained nearly 2% in December and 22% for the year. Much as in the United States, supportive monetary policy (in Europe and Japan) was one factor that helped stocks. On the economic front, the picture is more mixed. While Europe exited recession, many countries continue to struggle with excessive debt and weak economies. While Japan’s stock market was the top performer in 2013, it remains to be seen whether Prime Minister Shinzō Abe’s plan for dealing with deflation and sparking economic growth delivers on its initial promise. Finally, amidst the positives, emerging markets were strikingly divergent as softer economic growth generated investor concerns and the potential Fed taper roiled markets further.
The core, investment-grade bond market suffered a rare calendar-year loss, falling 2%, its first decline since 1999. Results were driven by a general preference for risk assets as the economy recovers and investors seek higher returns, as well as concerns about a potential change in U.S. monetary policy. We review the performance of our portfolio positions in the commentary that follows, in addition to providing our outlook for the asset classes we cover.
The Improving Macro Picture
We find ourselves with a more sanguine big-picture view, at least over the nearer term, than we have had in some time. U.S. and global economic fundamentals gradually improved over the past year across a number of dimensions, and seem poised for continued improvement or at least stability in 2014. Unfortunately, the risks related to excessive global debt, subpar growth, and unprecedented government policy that we have worried about since the aftermath of the 2008 financial crisis still remain largely unresolved. But before we revisit our concerns, let’s quickly run through some of the key positives.
the global economy slowly strengthens
At the broadest level, the growth rate for the global economy (which the International Monetary Fund estimates at 2.9% for 2013) improved in spots over the year and seems set to increase at least modestly next year. On a year-over-year basis, the U.S. economy grew at a real (i.e., inflation-adjusted) rate of around 2% in 2013 (through the third quarter), Europe finally emerged from recession, and the United Kingdom (2.6%) and Japan (2.1%) also generated modest but positive growth. Emerging-markets’ growth was disappointing overall in 2013, but they should benefit from improved export demand in developed markets next year. As shown in the chart at right, the leading indicators index produced by the Organization for Economic Cooperation and Development recently rose above 100 and is increasing, which indicates an economic expansion is underway. The indicators are designed to provide early signals of turning points between the expansion and slowdown of economic activity, and are based on a wide variety of data collected by the OECD from its 33 developed country members and a handful of emerging countries.
Manufacturing is a particularly bright spot with the J.P. Morgan Global Manufacturing Purchasing Managers’ Index hitting its highest level since February 2011 and also signifying an accelerating economic expansion. The PMIs are based on monthly surveys that provide advance indication of what is happening in the economy by tracking changes in production, new orders, inventories, employment, and prices.
housing and labor gains help boost the u.s. economy
Specific to the U.S. economy, there are a number of positives extending a trend that we highlighted in our commentary at the end of 2012.
- The housing market continues to improve. For example, the widely followed S&P/Case-Shiller Home Price Index was up 11% from a year earlier, and CoreLogic reports the percentage of homeowners who owe more than their homes are worth fell to 13% (as of the third quarter) compared to 22% a year ago.
- Along with the surging U.S. stock market, the strengthening housing market boosted household net worth to new highs.
- The labor market continues to gradually improve. Nonfarm payrolls (the net new jobs created in the economy each month) averaged a solid rate of nearly 200,000 per month during 2013 (although that is still below the pace of job growth during a typical economic recovery), and the unemployment rate dropped to 7% in November. Of course, as we and others have pointed out, much of the decline in the unemployment rate has been driven by a drop in the labor participation rate to 30-year lows.
An improved debt and credit picture bodes well for consumer spending
Household deleveraging (i.e., debt reduction and repair of consumers’ balance sheets) continued apace and household debt appears to be well along the path toward reaching more sustainable levels. The household debt/income ratio, a measure of the willingness and ability of consumers to increase their borrowing, has dropped 20% from its peak in 2007, and is now back where it was in 2003 and in line with its long-term historical trend.
Meanwhile, household debt service and financial obligations ratios remain at historically low levels thanks to extraordinarily low interest rates engineered by the Federal Reserve, along with modest income growth. Furthermore, credit conditions (i.e., credit availability and cost), as measured by a variety of indicators, also continue to improve and remain relatively loose.
These indicators bode well for an improvement in consumer spending, or at least limited further consumer retrenchment.
inflation is low, monetary policy remains supportive, and the budget deficit has declined
Inflation in the United States (and globally, with a few exceptions) is low and remains well-contained due to subpar growth and significant slack (excess capacity) in the economy. While most commentators talk about the inflationary risks from overly accommodative Fed policy (and we agree that is a medium- to longer-term risk), there remains a more immediate risk of continued disinflation (a falling inflation rate). In 2013, the price index for personal consumption expenditures—the Fed’s preferred measure of inflation—fell further below its target of 2%. As of November 30, 2013, the core PCE index (which excludes food and energy prices) stood at 1.1%, its lowest level since early 2011. The headline PCE inflation rate (which includes food and energy prices) was just 0.9%. On the other hand, if the economy gains some momentum and unemployment comes down further we will likely see increased wage pressures, which would put some upward pressure on inflation. (Rising wages would also pressure corporate profit margins, which as we have repeatedly noted—and note again later in this commentary—remain at/near historical highs. This would have negative implications for earnings growth and stock market performance.)
Related to the inflation picture, developed country central banks are likely to remain highly accommodative at least over the next year or two in terms of holding short-term interest rates at extremely low levels, and in some cases also providing additional liquidity via quantitative easing bond purchases. Specific to the United States, at its December 18, 2013, meeting the Fed initiated tapering of QE bond purchases by $10 billion, to $75 billion per month. Fed chairman Ben Bernanke also stated that if the Fed sees continued improvement in labor market conditions along with stable inflation it “will likely reduce the pace of asset purchases in further measured steps at future meetings.” If so, QE would likely be finished before year-end 2014 (there are eight Federal Open Market Committee meetings each year).
But importantly, the Fed also reinforced its intention (a.k.a. “forward guidance”) to keep the federal funds policy rate at near zero for the foreseeable future, including “well past” the point when unemployment drops below 6.5%. Moreover, Bernanke was clear that the Fed remains concerned about inflation that is too low and anticipates keeping rates low at least until inflation clearly moves back toward its 2% objective.
The U.S. federal budget deficit has come down sharply over the past year, and, with the recent bipartisan two-year budget agreement, the drag on GDP growth from fiscal policy tightening will be reduced in 2014. This compares to 2013 when tax increases and “sequester” spending cuts shaved 1.5 percentage points off of GDP growth, according to Congressional Budget Office estimates. The two-year budget deal also greatly reduces the threat of another government shutdown during that span. However, another ugly political fight over the debt ceiling remains a possibility later in the first quarter of 2014. And the need for a credible medium- to longer-term plan for government deficit and debt reduction remains.
So, there are many macro positives that should not be ignored, but it is important to remember that just because economic fundamentals are improving doesn’t necessarily imply a strong year for the stock market. Valuations, earnings growth, interest rates, and overall investor sentiment/psychology (to name a few) are likely to be much more important drivers of market returns. The stock market is a discounting mechanism, so presumably it already incorporates positives like stronger economic fundamentals as this evidence comes out. This is reflected in what we still see as unattractive/high valuations (even given our more sanguine macro outlook). So, we wouldn’t be surprised to see a decent year for the global economy, but a weak year for U.S. stocks after the very strong rally in 2013. There also remain significant macro risks and uncertainties that continue to influence our investment outlook and portfolio positioning as we look out over the next five years. We will discuss those next.
macro risks, negative considerations,
and uncertainties remain
Wage growth and income growth in the United States remain subpar, although both have been increasing since late 2012. Weak income growth implies that consumer spending is likely to be subdued even as consumer deleveraging becomes less of a headwind. With consumption accounting for roughly 70% of U.S. GDP, this suggests continued sluggish economic growth absent a significant increase in consumer borrowing or reduced saving.
Overall U.S. debt levels remain very high and the projected growth in government debt and entitlement spending relative to GDP is still too high to be sustainable over the very long term. Resolving this without causing an economic contraction is likely to be challenging, even in a normal growth environment.
The chart to the right shows total household, government (federal, state, and local), and nonfinancial corporate debt as a percentage of GDP. It is still right near the all-time post–World War II high, due to continued growth in government and corporate debt.
Beyond the economics of deleveraging, the situation is made even more challenging due to the U.S. political dysfunction. The ability to forge compromise and progress on the country’s longer-term debt/deficit situation remains highly uncertain, although there may be signs of light reflected in the recent bipartisan budget agreement. It’s possible that the political dysfunction hit a low point with the government shutdown fiasco last fall. And public opinion of Congress is so low there is the potential for a positive surprise in this regard (though we won’t hold our breath.)
Fed monetary policy is still far from normal and, although the QE taper has begun, there remains a great deal of uncertainty as to how the Fed will exit from its zero fed-funds rate policy and unwind its huge balance sheet (currently at $4 trillion, or 22% of GDP, and still growing due to bond purchases) without causing an economic or market shock. We think it’s more likely than not that the Fed will err on the side of tightening monetary policy (raising rates) too late rather than too early, and that inflation will become an issue for the financial markets, which would be a negative for both stocks and bonds. But as discussed above, that is not an immediate concern. Given the Fed’s policy pronouncements as well as their unpleasant experience with the market’s reaction to last summer’s “taper talk,” we’d put a low probability on the Fed tapering or tightening too aggressively. But policy errors in either direction are certainly possible. (The change in Fed leadership from Bernanke to Janet Yellen is unlikely to lead to a significant change in policy.)
Despite exiting recession in 2013, the eurozone economy remains very weak, with structural imbalances between creditor and debtor countries that are still far from resolved. There remains a meaningful risk of deflation and a debt crisis stemming from the weaker peripheral countries. The banking system is undercapitalized and in need of a credible region-wide banking union backstop (and recent efforts on this front are far from sufficient). In October, eurozone inflation fell to 0.7%, which prompted the European Central Bank to make a surprise interest-rate cut to a record low 0.25% amid rising fears that Europe might follow in the footsteps of Japan’s “lost decades” of stagnation and deflation. Meanwhile, eurozone unemployment climbed to more than 12% in 2013 and is at much higher levels in the periphery (e.g., 27% in Spain), causing social unrest with the potential to spiral into a more serious crisis.
Risks in the financial system related to China’s debt/infrastructure spending bubble remain. While it is encouraging to see China’s new leadership acknowledging and addressing the cyclical and structural imbalances in their economy, it is no guarantee they can successfully manage them without a major disruption. At least partly reflecting these risks, the Shanghai stock market ended 2013 down 13% from its highest point earlier in the year, and down nearly 7% for the year overall.
Japan is the world’s third largest economy, so the success or failure of “Abenomics” (prime minister Shinzō Abe’s wide-ranging plan for reinvigorating Japan’s economy) is a wild card that will have important global economic and market implications. We don’t have a high-conviction opinion as to its ultimate outcome—just recognition that it’s another manifestation of an unbalanced and weak global economy, and the extremely aggressive and unconventional policies that are being undertaken to try to turn things around.
the big picture in summary
While there have been fundamental improvements in the macro environment over the past year, many big-picture risks remain as we look out over the next five years. We are not confident in predicting that any of these risks will actually play out, but we think many of them have a reasonable likelihood of happening (and many of these risks are interrelated, meaning if one happens others are more likely to occur as well). If so, the consequences for financial markets and asset prices would likely be severe. Although there don’t appear to be any near-term catalysts, we believe it remains prudent to manage our balanced portfolios with these risks—and their potentially significant market impacts—firmly in mind. This is particularly so, given our assessment that current valuations for U.S. stocks (in aggregate) are not sufficiently pricing in the potential impact on the market if these risks actually do play out.
Investment View: Looking Back and Looking Ahead
With that macro backdrop, we’ll move now to a discussion of our portfolios, looking at some of the key developments in the financial markets over the past year, their impact on performance, and our investment outlook heading into 2014. Before doing so, though, we feel compelled to reiterate that we don’t invest based on a one-year outlook or time horizon. Similarly, we don’t judge the success of our investment decisions (or those of the fund managers with whom we invest) on a one-year basis. But, it is human nature at year’s end to look back at what transpired over the past 12 months . . .
We appreciate your confidence and trust.
-Your Capital Trust & Associates, LLC Research Team
As always, please feel free to call Sam or email with questions and comments to firstname.lastname@example.org
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