Download Overview Investment performance for 2013 proved to be very strong

The Stevens Advisor
Stevens, Foster Financial Services, Inc.
Securities offered through LPL Financial, Member FINRA/SIPC
7901 Xerxes Avenue South, Suite 325
Bloomington, Minnesota 55431
www.stevensfoster.com
[email protected]
Ph: 952.843.4200
January 10, 2014
Volume 11, Issue 1
Toll Free: 877.270.4200
INVESTMENT OUTLOOK 2014
Overview
Investment performance for 2013 proved to be very strong for U.S. equities as the S&P 500
large cap index gained 29% and produced its best return since 1997. Last year’s eventdriven concerns related to the “fiscal cliff” and budget cuts from sequestration were no
match for a resilient U.S. stock market. Although economic growth was low compared to
typical historic levels, the markets moved upward in response to the Federal Reserve’s
continued Quantitative Easing (QE) monetary stimulus. The QE practice of buying U.S.
Treasury and mortgage bonds was designed to drive interest rates lower and make equity
investments relatively more attractive. The Federal Reserve’s goal was to gradually reduce
(taper) these purchases and ultimately eliminate them as economic fundamentals
strengthened. The Fed announced recently that they would begin reducing bond purchases
and the markets moved up sharply. We are greatly encouraged that the Fed is on track to
reduce its role in the U.S. economy. We believe that 2014 marks the beginning of a
transition to a focus on the fundamentals rather than a reaction to global central bank
stimulus initiatives. Investor confidence should increase based on economic growth rather
than extraordinary public policy support.
For the last several years, our outlook has been for weak economic growth, and that is what
has happened. Now, however, we believe that the U.S. economy is accelerating towards a
more normal 3% growth rate. In addition, Europe has emerged from recession, China is
showing signs of stabilization, and other developing countries are also showing fundamental
reacceleration. As a result, we see synchronized global growth for the first time since 2010
and this should result in global growth at the highest level since the 2008 recession. As we
look to 2014 we see the prospect for increased market volatility, but the improving overall
global growth is ultimately expected to contribute to positive stock market performance.
The global growth is also expected to contribute to rising interest rates, and the broadbased bond market is expected to experience another year of modestly negative returns.
Central Bank Role
Starting in December 2008 the U.S. Federal Reserve pursued the most aggressive stimulus
program in its history. This was accomplished by cutting the target for the federal funds
rate to a range of 0-0.25%, by providing forward guidance that said short rates would stay
low for an extended period of time, and finally by using Quantitative Easing-QE. QE meant
that the Fed would purchase U.S. Treasury and mortgage bonds to drive up bond prices and
drive down interest rates. These lower interest rates would help support the economy, and
make equities relatively more attractive than fixed income. Over time the QE program
expanded the Federal Reserve balance sheet to $4 Trillion. It was always recognized that
QE would need to end, but the question was when and how it would be wound down. When
Fed Chair Ben Bernanke first discussed the gradual reduction of QE purchases on May 22,
the markets sold off hard. Since that time the markets have priced in a longer-term view
that economic growth is improving and there is less need for monetary stimulus. As a
result, when the Federal Reserve announced on December 18 that they would begin
reducing bond purchases from $85 Billion/month to $75 Billion/month, the markets moved
up sharply.
Central bank monetary initiatives were not limited to the U.S. Since the 2008 financial
crisis, the global marketplace has been awash in central bank stimulus. Most developed
countries drove their interest rates down to historic lows, and foreign central bank bond
purchases came to $4 Trillion, roughly the same level of purchases as in the U.S. During
this period, global economic growth has been very anemic by historical standards. For
example, average real GDP growth for the last four years has been only 2.2% for the U.S.,
0.9% for Europe and 1.9% for Japan. Along with this sub-par economic growth has been a
weak labor market. U.S. unemployment has declined from a 10.0% peak in October 2009
to a still-too-high current level of 7.0%. Unemployment in the Eurozone averages 12.1%,
and the rate for youth in some countries is near 50%.
These hugely expansionary monetary policies pursued by the biggest central banks in the
developed world have helped support market prices, and these policies will only be
gradually reduced in the future. Consequently, this liquidity will continue to help support
market prices in 2014. It seems clear that these large, unprecedented central bank bond
holdings will shape the future global investment environment for a number of years, and we
have a longer-term concern about how these central bank bond holdings will eventually be
wound down. The prolonged period of low rates may cause unintended consequences for
financial stability. What is needed is a smooth transition from central bank stimulus to self-
sustaining private sector growth. This involves the risk that central banks wait too long
before slowing the stimulus and risking inflation.
Market volatility was relatively low in 2013 partially due to $150 Billion/month of global
central bank purchases. 2013 marked the lowest volatility during the business cycle, as
measured by a maximum peak-to-trough decline in the S&P 500 of only 5.7%, the smallest
of any year since 1995. As the U.S. and other countries gradually reduce these purchases,
the support from a relatively price-insensitive buyer declines. When this happens, market
volatility is expected to increase.
U.S. Economy
U.S. GDP growth over the last four years has been a lackluster 2.2%, compared to a 4.1%
average for the first four years after other post-war expansions. If our economy had grown
at the historic rate, it would have added $1.25 Trillion to our economy. While
unemployment has declined from 10.0% to 7.0%, there are still 10.9 million unemployed
and U.S. private sector employment is still 1.5 million below its pre-crisis peak. Income
growth has been stagnant and job creation has been at lower income levels rather than
higher-wage jobs. It needs to be noted that the Minnesota did not endure the brunt of the
recession, and our job growth has been stronger. The Minnesota unemployment rate is
4.6% and our state has recovered all jobs lost in the recession.
Although we experienced a tepid economic recovery, recent trends are much more
favorable. The U.S. economy grew at a 4.1% annual rate in the third quarter based on
broad gains in consumer spending, home construction, manufacturing production, and
increased hiring. The Commerce Department also reported that November core Durable
Goods, a category that tracks business investment, rose 4.5% on rising demand for goods
across a broad spectrum of industries. The federal budget deficit has fallen from 10% to
4% of GDP. Banks are recapitalized and increasingly working off bad loans. The household
sector has greatly reduced its debt service costs and the housing market has recovered.
Finally, state and local tax revenue is increasing and this sector is no longer cutting
budgets. Weak government spending over the last three years has subtracted 0.5%/year
from GDP. This economic drag is expected to diminish as we go forward in time. As we
look to the future, we see pent-up demand at both the consumer and the corporate level.
Corporate cash stands at a hefty 11.1% of assets and allows a pick-up in capital spending.
The manufacturing sector is advancing strongly, and exports are rising nicely.
Political brinksmanship characterized the last two years, but the political process finally
achieved a modest compromise earlier in December. Republican House Budget Chair Paul
Ryan and Democratic Senate Budget Chair Patty Murray of Washington State were able to
craft a budget compromise to avert another government shutdown. This removes
uncertainty, and helps confidence. We still face a debt ceiling deadline of February 7, 2014
but the Treasury will still be able to use “extraordinary measures” to go beyond that date.
We are hopeful that the politicians can find more common ground related to the debt
ceiling.
Future U.S. GDP strength is supported by less impact from Federal fiscal tightening, the
ongoing housing recovery, solid consumer spending, and improving business capital
spending. GDP gains are also based on increasing stability in Europe and reacceleration in
emerging markets. The U.S. economy has been performing far below its potential ever
since 2008, and this phenomenon is known as the output gap. The output gap reflects the
difference between potential GDP and actual GDP.
Although this output gap has been too
wide, it precludes imminent inflation.
Corporate Earnings
U.S. 3Q13 corporate earnings came in at a record $1.869 Trillion annualized rate according
to the Commerce Department’s Bureau of Economic Analysis. Based on 2013 corporate
earnings reports for the companies in the S&P 500, earnings are expected to come in at a
record $106/share, and the Wall Street 2014 consensus expects S&P 500 earnings at $116.
Corporate profits in the recent 3Q13 GDP report came in at 11.1% of GDP, the highest level
since records started in 1947. These increased earnings are important for continued growth
of the stock market.
Although corporate earnings are at record levels, the growth rate is being driven by lower
costs rather than by strong revenue growth. This raises the longer-term question regarding
the sustainability of earnings growth. Compensation represents roughly 65% of corporate
expense, and employee compensation as a % of GDP is at its lowest level in nearly 60
years. The share of wages on corporate income statements has remained low as companies
have been reluctant to hire. Moreover, corporate interest expense has declined due to
historically low interest rates. Lower Effective corporate tax rates have fallen and this also
contributes to increased profitability.
Although U.S. corporate earnings growth rates have been heavily impacted by lower costs,
we expect that any profit/margin erosion will not be precipitous. Positive earnings factors
for 2014 include an expanding global economy that will support modest increases in prices
and in revenue growth. We expect hiring to pick up, but the labor market has significant
slack, so there is little wage pressure at this time. Finally, corporate earnings per share will
continue to be supported by share repurchases. For example, Morgan Stanley sees a 3%
2014 net share reduction. European corporate profits are improving significantly based on
their recovery from the recession. Emerging market corporate margins have been under
pressure and there is upside to profit growth.
Although the S&P 500 index is up over 29% so far this year, it is still near average historic
valuation levels of the past 25 years. The valuation level for the last twelve months is also
below the 17-18 PE where every secular and cyclical bull market has ended in the postWWII era (except for the late 1990s when it was even higher). Foreign stocks continue to
trade at discounts to their average historic levels and emerging markets trade at steep
discounts to historic levels.
Sectors
From a sector standpoint, we continue to maintain an overweight in the Information
Technology sector. Technology companies are very profitable with a strong Return On
Equity of 22% over the last twelve months compared to 15% for the S&P 500. These
technology companies are able to participate in rapidly growing parts of our economy that
are attracting significant corporate capital expenditures. For example, the Morgan Stanley
Chief Information Officer survey shows that cloud computing currently handles 7% of
current computing workloads, but this is expected to grow to 17% by the end of 2014.
These tech companies have strong balance sheets with minimal interest expense, and they
have relatively low valuation levels.
Real estate underperformed in 2013 as rising interest rates attracted yield-oriented
investors away from real estate holdings, and rising rates also increased borrowing costs.
We are maintaining our overweight for several reasons: supply has not kept up with
demand so we expect favorable future leasing terms, employment growth is improving and
this improves occupancy, valuations are now below historic average levels, and real estate
historically trades off with initial fears of rising rates, but then regains performance as
economic growth improves.
We do not currently hold any alternative investments, but we see significantly greater
volatility in 2014 and we plan to increase this asset class to help mitigate this risk. Given
our view of the increasing potential for greater short-term volatility in the markets, the
scope of our investment exposure may involve the use of alternative investments, to
mitigate risk by providing stability to our portfolios in a declining stock market and
insulating fixed income price losses in a rising interest rate environment. We view an
allocation to this objective to be strategic given the uncertainty of how global economic
policy may unfold and the trajectory of the Federal Reserve’s move to taper. For our
purposes, an allocation to this asset class will be through the use of liquid publicly-traded
pooled investment products that use traditional hedge fund strategies such as long/short,
global macro, event driven and also investing in commodities and currencies.
International
Recent economic data show that international economic growth is trending upward at a
stronger rate, just as it is in the U.S. This progress includes Europe where the financial
crisis is no longer making headlines. Europe reported positive economic growth in 2Q13
and 3Q13 after six consecutive quarters of negative growth. This is significant progress
considering the fact that two years ago the pundits were questioning the viability of the
euro. The Organization for Economic Cooperation and Development reported on December
9, that composite leading indicators in most major developed and developing countries are
improving.
Part of the credit for European improvement goes to the European Central Bank-ECB which
in 2012 was finally able to calm sovereign bond markets. Positive ECB initiatives were
achieved through two massive Long Term Refinancing Operations that provided cheap longterm credit to European banks. The ECB also articulated a policy for an Outright Monetary
Transactions program that pledged to protect the sovereign bond market in return for
adherence to fiscal adjustment programs. For example, the ECB drove bond yields down in
troubled peripheral countries, such as the drop from 16% to 6% in Portugal that took place
in just months, without having to actually do much more than state its intention to support
Eurozone member debt.
Structural reforms have improved the competitiveness and productivity in both the core and
the peripheral countries. Exports are increasing and international current accounts are
improving. Europe’s rising Purchasing Manager Index readings for both the core and
periphery are above 50, and this indicates the manufacturing sector is expecting improved
economic growth. Euro-area unemployment dropped to 12.1 percent in October from 12.2
percent a month earlier, but much more progress is needed. Inflation is running far below
the ECB target of 2%, and the Eurozone faces deflationary pressures. The possibility of
deflation is a serious risk, but it gives the ECB room to increase monetary stimulus without
risking imminent inflation. Although the Eurozone is showing growth, the region faces
muted progress as they deal with weak credit growth and rising non-performing loans.
Deutsche Bank estimates that Europe’s periphery banking system has between 1.5 trillion
and 2 trillion euros of non-performing loans.
European Central Bank policies and increasing economic fundamentals for both the core and
periphery have moved the Eurozone out of crisis mode, but there is much work to be done.
The Eurozone needs a weaker euro to increase exports to provide stronger economic
growth. A European banking union with a single bank-resolution mechanism is also
necessary. This entity needs to be responsible for deciding which banks to shut down and
which to save. The ECB has established the Asset Quality Reviews program for banks
during 2014, and this should provide better disclosure to help bolster confidence in the
stronger banks.
Japan
Japan has reversed decades of weak economic growth and poor investment performance
through the aggressive initiatives of Prime Minister Shinzo Abe and Bank of Japan Governor
Haruhiko Kuroda. These policy initiatives, dubbed Abenomics, include the “three arrows”:
fiscal stimulus, monetary expansion, and economic reform. These policies have achieved
short-term gains by weakening the Yen and driving the Nikkei index up this year over 55%
to its highest level in six years. These policy initiatives are probably sufficient to support
their economy and investment gains for 2014, but there are longer-term issues. For
example, Japan is on track to run a general government budget deficit of 9.5% of GDP this
year, and gross government debt is expected to constitute 245% of GDP. If Abenomics
doesn’t work on a longer-term basis, Japan could eventually suffer a huge debt crisis.
Under this scenario, the Yen would collapse and inflation would rise. Unfortunately, Japan is
also troubled by territorial squabbles with China.
Emerging Market
Investment performance for 2013 emerging markets has been weak due to economic
growth that proved to be slower than expected, and also due to capital flight. Based on
International Monetary Fund projections, emerging market growth in 2013 is coming in at
4.5% but this is still higher than developed markets growing 1.2%. For 2014 the IMF Fund
projects emerging market growth at 5.1%, compared to 2.0% for developed economies.
Emerging markets economic growth rates are down somewhat from longer-term historic
averages, but they are still growing at a relatively strong rate. Emerging markets were
driven by a higher proportion of extractive industries, and they previously benefitted from a
decade-long commodity boom. The commodity factor is slowly being displaced by a
growing middle class and increased consumer spending. Emerging markets growth was
also related to weaker Chinese imports, but China is now showing stronger growth.
Capital flight was precipitated by rising global interest rates earlier in 2013. Emerging
markets were significant beneficiaries of the two-decade decline in interest rates. Declining
global interest rates caused developed market capital to flow into emerging markets. When
Fed Chair Ben Bernanke announced in May that the Federal Reserve would begin to taper
their bond purchases, this caused U.S. interest rates to rise. This meant that some fast
money moved from emerging market countries (deemed riskier) to the U.S. Fund flow data
for US-based mutual funds and Japanese flows suggest that all the retail money that flowed
into the asset class by May was out by September, while institutional inflows continued
albeit at a slower pace.
Recent fund flow data suggests that global money manager
emerging market exposure is now at its lowest level in many years.
Although emerging market performance was weak in 2013, it has strongly outperformed in
8 of the last 11 years and we continue to see solid growth fundamentals. In aggregate,
current accounts are in surplus, debt levels are modest and external debt is low. Emerging
markets are currently trading at hefty discounts. While emerging markets corporate profit
margins have been under pressure, there is upside to profit growth.
We expect improving growth in 2014 and beyond based on the following long-term trends:

A rising middle class and rising real wages have boosted emerging market
consumption.

Better demographics with younger work forces.

Urbanization and greater access to financial services and health care.

Great productivity potential due to automation and improved management.

Better fiscal balances.

Healthier external balances and positive aggregate current accounts. The emerging
markets crisis in 1997-98 was hurt by currencies pegged to the U.S. dollar, and most
of these countries no maintain floating currencies.

Lower debt levels and stronger sovereign credit ratings.
Emerging markets remain a more volatile asset class, and prospects for various countries
are diverging. We have a preference for emerging markets countries with positive current
accounts driven by domestic consumption, not commodity exports. Good examples include
China, South Korea, Singapore and Taiwan. As U.S. interest rates rise and the U.S. dollar
strengthens, countries with weaker current account deficits like India, Indonesia, Brazil,
South Africa and Turkey have seen a rapid depreciation of their currencies. This currency
weakness leads to inflation concerns that can leave local governments in a quandary. They
must tighten liquidity conditions to fight currency depreciation and inflation. However
reining in liquidity can further weaken a deficit country’s current account. Ultimately there
are capital outflows. Emerging markets also face increased risks due to: less developed
capital markets, weaker corporate governance, and a perception that these countries are
inherently more risky than developed countries. This perception of increased riskiness
translates into a more volatile asset class.
Emerging Markets-China
No discussion of emerging markets is complete without commentary on China. China has
grown to be the second largest global economy, behind only the U.S., and it represents a
big export market for many emerging market countries. China’s economic growth rate
decelerated from over 10%/year to 7.5% in 2013, and there was a concern of a hard
landing where growth would decelerate to roughly 5%. Economic growth in the past had
been supported by exports and by credit-driven infrastructure investments, but the export
growth rate has been weaker, and infrastructure spending got far ahead of actual needs.
Chinese leaders recognized that they needed to transition to a more consumer-driven
economy, and consequently they articulated a series of reforms in their Third Plenum
planning meeting to establish a broad agenda for the next 5-10 years. The Third Plenum
established positive reforms:
-Interest rate liberalization. Rates were controlled by the government and were used to
prop up banks. Freeing-up interest rates (no longer punishing savers) and liberalizing the
Renminbi currency provides more efficient capital utilization.

Curtailing shadow banking. Shadow banking involves private entities trying to work
around a broken banking system.

Allowing land ownership in rural areas. This would be the biggest wealth transfer in
history. It makes capital portable and some predict mass migration to the cities.

Dismantling of the hukou system of residency permits that prevents rural migrants
from using social services in cities. Hukou is a social entitlement system somewhat
like U.S. Social Security system and is the 3rd rail in China, but it appears they are
reforming it.

Market-based reform measures. Reforming the energy, utility, transportation and
telecom sectors is expected to help restore productivity and confidence of private
sectors.

Relaxing the one-child policy.
A greater opening of capital markets and genuine currency convertibility are still to come.
Credit risks also remain within the shadow banking system, and China’s financial system is
structured with short-term financing for long-term assets. Finally, environmental pollution
and corruption remain as significant problems.
China’s reforms are focused on slowing economic growth, the risk of a financial crisis and
the risk of social instability. China is making clear progress in the transition from an
investment-led economy to a consumer-driven one with 2013 retail sales up 12% compared
to last year. Their manufacturing sector is also showing a faster pace. The HSBC
Purchasing Manager composite output index rose to 52.3 in November, from 51.8 in
October, the biggest monthly move in 8 months. Factory activity grew at the fastest pace
since March. New orders for goods producers were strong as well. BlackRock says that
China is taking the necessary steps to sustain long-term growth that could set the stage for
a multi-year bull market in Asian equities.
Fixed Income
In 2013, the 10-year U.S. Treasury yield fell as low as 1.6% and rose as high as 3.0%, a
remarkably wide range compared to historic norms. Broad-based fixed income portfolios
such as the Barclay’s Aggregate Bond Index are on track to decline 2.1% during 2013, but
there is a wide range of performance between the various fixed income asset classes. U.S.
Treasuries with 20+ year maturities were down 13.4%, while high yield corporate bonds
were up 7.4%. As we look to 2014, we expect long-term interest rates to continue to rise
and that will cause investment performance among the various bond categories to be
relatively similar to 2013. Longer maturities are expected to be most negatively impacted.
Meanwhile, bonds with higher credit risk should benefit from higher interest rates and less
vulnerability to rising rates. We expect the Fed to begin to raise short-term fed funds
interest rate in 2015, and then gradually raise this rate through 2016. The market should
begin anticipating rising shorter-term interest rates as the year progresses, and this should
force yields on shorter maturities to rise.
Our Expectation
Based on the investment factors listed above, we believe that the improving economic
growth rate should support positive equity performance by the end of the year, and equities
should outperform bonds. We also believe that markets will be much more volatile than in
2013, and we will be making tactical adjustments as the year progresses. Finally, we will
continue to work with your Client Account Manager to help ensure that your portfolios will
be managed to help you pursue your long-term goals.
–Jeff Johnson, CFA, December 31, 2013
“The Stevens Advisor” is a market update from sources deemed reliable, but Stevens, Foster Financial Services, Inc. does not make
any warranties of its accuracy. The opinions and forecasts are those of the author and may not actually come to pass. The
opinions voiced herein are for general information only and are not intended to provide specific advice or recommendations for any
individual. Past performance is no guarantee of future results.