Download Quick Market Update. Six Possible Surprises for 2014

Quick Market Update
Six Possible Surprises for 2014
JANUARY 10, 2014
In this Quick Market Update:
H. Cameron Hinds, CFA®
Regional Chief Investment Officer
Carol M. Schleif, CFA®
Regional Chief Investment Officer –
Abbot Downing
We outline six issues that may not be on investors’ radar but
could impact markets in the coming year:
» The U.S. markets could keep “melting up.”
» Bond investors may “head for the exits.”
» Emerging markets might “re-emerge.”
» Foreign cash repatriation could push U.S. stocks higher.
» Global geopolitical risk may return.
» Volatility might surge.
Attempts to forecast global economies and markets are fraught with imprecision. Today’s jobs report is an
example of how unexpected data can surprise even the most experienced forecasters. Consensus estimates
for 200,000 new jobs in December proved to be overly optimistic when the actual numbers were reported
this morning at a mere 74,000 new jobs. Likewise, few market observers predicted last year’s strong,
developed-market equity performance. Indeed, last January, the fiscal cliff and sequestration cuts had many
investors lowering their expectations for equity markets in 2013. Developed-market stocks charged out of
the gate, however, and didn’t look back. Other market observers made predictions of escalating inflation, a
“great rotation” out of fixed-income investments and strong emerging-market performance which didn’t
work out very well either.
With U.S. equity markets in record territory, investors want to know what’s next. Can U.S. equities stage an
encore performance? Will emerging markets and commodities continue to suffer? Will interest rates keep
rising? Will we see inflation or deflation? Will political divisiveness continue? In this Quick Market Update,
we highlight six possible surprises for the coming year. In investing, it’s typically not the headlines that are
problematic; it’s the unnoticed story about to grace the headlines that may have the most notable shortterm impact for investors.
The U.S. markets could keep “melting up”
While another 30 percent increase in U.S. stocks in 2014 is a low-probability event, signs of overheating in
the equity market are not readily apparent either. Corporate fundamentals remain strong, with low
inflation, high productivity, and solid sales. Judging from mutual fund flows, the long-anticipated great
rotation out of fixed income and into equities has barely begun. (See chart 1 below). It appears that many
investors, stung by the ‘Great Recession,’ remain wary of equity investments. This lingering reluctance could
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fuel demand for stocks in the coming quarters as many investors move from fear of loss to fear of being left
behind.
Chart 1: Flow of Funds – Cumulative Net New Cash Flow (2007-2013)
1,400
$ Billions
1,000
Total Bonds, Nov-13: 1123.44
Total Equities, Nov-13: -302.68
600
200
-200
-600
2007
2008
2009
2010
2011
2012
2013
Source: FactSet, 1/8/14
Bond investors may “head for the exits”
At year-end 2012, the 10-year U.S. Treasury yield stood at 1.78 percent. Twelve months later, it was up 126
basis points to 3.04 percent, yet core inflation remained tame and developed-market stocks had soared.
Billions of dollars have been invested in fixed-income funds of all flavors in recent years; $1.8 trillion in the
five years ended 2012 alone. However, for some categories of bonds, returns turned negative in the second
quarter of 2013. We suspect that when investors review their annual performance numbers in a few weeks,
there will be a lot of handwringing over fixed income vs. equity returns. Nervous bond-fund investors could
exert a much more destabilizing impact on fixed-income markets over the short term than is widely
anticipated.
Rising bond yields, inflation, debt and deficits are all independent issues, even if the media frequently
chooses to stuff them into the same worry closet. Moderate inflation could actually be a good thing for
employees and companies (pay raises and pricing power, anyone?). And, over time, rising bond yields could
be beneficial for aging baby boomers looking to lock in steady income streams or match cash flow with
liabilities.
Emerging markets might “re-emerge”
While global equity markets were strong in 2013, emerging-market equities were a major disappointment.
In retrospect, the underperformance of this sector was somewhat rational (it was the degree of
underperformance that appeared oversized). Many of the leading emerging economies clearly slowed in
2013. Commodity price weakness had a negative impact on stock markets in which commodities are
important exports. Emerging countries’ currencies also were quite weak, especially relative to the U.S.
dollar. Countries such as Brazil, India and Indonesia remain particularly vulnerable to currency weakness due
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to ongoing current account deficits; even as some emerging-market exporters see cheap currencies boost
their earnings prospects.
All of these trends seem to be persisting as we enter 2014. However, it would also appear that much of the
bad news is heavily discounted as emerging-market valuations as a whole remain relatively appealing. In
particular, valuations are historically cheap in countries such as Russia, China, India and Indonesia. Yet
concern over a continued slow-down in their respective economic growth rates persists. Given the weak
performance in 2013 and current economic trends, some emerging markets may find a footing in coming
quarters. Although a quick and significant positive turn in emerging-market equity performance likely would
be viewed as a major surprise in 2014.
Foreign cash repatriation could push U.S. equity markets higher
U.S. companies with significant international operations have huge excess cash balances in over-seas
accounts. Estimates indicate the balances could be as much as $2 trillion, and 50 percent of the reserves
reside in two sectors—health care and technology. These foreign cash holdings are growing at an increasing
rate. In 2004, 30 percent of the S&P 500 Index pre-tax profits were earned internationally. This percentage is
on track to approach 50 percent in 2014.
Understandably, companies are quite hesitant to pay significant U.S. taxes to bring cash back to the U.S. In
2004, Congress gave companies a “repatriation holiday” with a 5.25 percent tax rate. This resulted in
approximately 45 percent of overseas cash being returned to the U.S.—approximately $360 billion in cash. If
a similar policy were enacted in 2014, companies could potentially bring $1 trillion back to the U.S.
There has been some discussion in Congress of a tax repatriation holiday, but we do not envision passage
without a major tax overhaul which appears unlikely at this time. Even so, we would not dismiss any strategy
that has the potential to generate new tax revenue, and repatriation could do just that. The question of
what companies would do with the cash is controversial. It would be more politically feasible if companies
were required to use the cash to increase capital spending and create new jobs. Yet that requirement is
virtually impossible to track and enforce. It is anticipated that companies likely would use a large portion of
the cash to buy back stock and raise dividends—a potentially major stock market positive that we believe is
largely unexpected among market observers.
Global geopolitical risk may return
With the exception of the events in Syria and North Korea, and a few regional skirmishes, geopolitical
tensions were fairly muted last year. In contrast, 2014 could potentially bring the reemergence of political
and economic instability which is currently unexpected by the global markets.
The list of potential catalysts for increased insecurity is large. In Russia, President Putin has been notably
amicable recently (most likely due to the winter Olympics), yet his influence in Syria indicates the potential
for new conflict to surface. Indeed, Russia could be ground-zero for political instability in 2014. Slowing
economic growth in China could produce increased social and political unrest (there is a strong correlation in
China between the Purchasing Managers’ Index (PMI) employment sub-index and an increase in social
unrest). This risk is likely to increase as China transitions from an investment-driven economy to one that is
consumption-driven. It is unclear if the Abenomics experiment in Japan will be successful, putting continued
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pressure on the yen. Eurozone policy-related concerns could reemerge in 2014. Finally, we note there are a
number of important elections in various emerging countries in 2014. It would appear that there is a great
deal of unexpected geopolitical instability that could surface this year, putting global markets at risk of a
pullback.
Volatility might surge
When volatility drops or there is an extended period when prices only rise, investors may become lulled into
thinking there is less risk in their portfolios when, quite often, the opposite is true. As the chart below
shows, one of the classic measures of short-term volatility, the Chicago Board Options Exchange Volatility
Index (VIX), has been quite subdued for nearly two years.
Chart 2: VIX (1990-present)
90
80
70
60
50
40
30
Average
20
10
0
90' 91' 92' 93' 94' 95' 96' 97' 98' 99' 00' 01' 02' 03' 04' 05' 06' 07' 08' 09' 10' 11' 12' 13'
Source: FactSet, 1/9/14
While the chart above shows that volatility can remain low for many years, it also illustrates how volatility
can spike when prompted by negative and largely unpredictable events. Currently, given richer valuations,
fewer attractive investment alternatives, reduced liquidity, and a panoply of global geopolitical concerns, an
unexpected shock could drive markets sharply downward.
Conclusion
While it is impossible to know if these surprises will occur in the coming year, they are all within the realm of
possibilities. It should be noted that risk-based strategies have performed well relative to low-risk strategies
over the past few years. Based upon some of the negative risks, we strongly believe now is not the time to
back away from portfolio diversification, even though it may be tempting to increase asset classes that have
recently outperformed. It could be rationally argued that maintaining a four-asset-group strategy (stocks,
bonds, real assets, and complementary strategies) is even more important today relative to five years ago
when risks were recognized and priced into securities. At a minimum we strongly encourage investors to 1)
ensure their long-term targets are in sync with their goals; and 2) consider rebalancing back to those targets.
After all, the most “predictable” thing about the markets in the short term is that they are largely
unpredictable.
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All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.
Disclosures
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