In late 2012, many economic and market commentators predicted that 2013 was to be challenging year. Most developed economies including the United States, were coming off a robust 2012, but accommodating monetary policy seemed to have done all it could and global governmental strife seemed to impede any coherent fiscal policy responses. However, economies and equity markets across the globe generally continued their upward ascent in the final quarter of 2013 capping a stellar year of performance. As we enter 2014, many economic indicators continue to be encouraging, but the risk aversion that has permeated the markets since 2008 still weighs and abates slowly. The following are some of the considerations that impacted 2013 conditions and that will likely have a bearing on results for 2014
- Monetary Policy – The Federal Reserve under new leader Janet Yellen. Ms. Yellen became the first woman in the 100 year history of the U.S. Central Bank, or any major central bank for that matter, to be elected as Fed leader and early indications are that she will follow in her predecessor’s footsteps in aiding the U.S. economy until the labor market is stabilized. Although the Fed trimmed its monthly bond buying program from $85 billion to $75 billion during the quarter, the total amount of such purchases remains immense. Remarks made by Ms. Yellen during the quarter that the economy and labor market are performing “far short of their potential” would seem to support expectations that Ms. Yellen is committed to former Fed chairman Ben Bernanke’s goal of maintaining quantitative easing until the unemployment rate falls below 6.5%. The Fed’s 2% inflation goal continues to be the caveat to this policy. If actual inflation remains muted continued easing is likely at least through the end of this year. Conversely, if the economy continues to strengthen and inflation picks up, more rapid termination of the bond buying would be likely. Although tightening may increase equity market volatility in the short run, our opinion would be that signs of more robust growth are a good thing for the markets longer term. Additionally, we have been reliant on significant monetary stimulation for a long time and a more favorable scenario would see economic expansion be able to continue on its own.
- Employment - The unemployment rate is down to 6.7%, but hiring remains tepid. The unemployment rate is currently at its lowest level in the past 5 years, but many companies remain cautious about hiring. It seems more apparent that even as the quantity of jobs improves somewhat, the quantity of jobs lost during the recession will never be duplicated. The impact to consumer consumption is limiting, however, the positive is that this employment capacity should mitigate inflationary pressures.
- Corporate Profitability - Bottom lines will require much more top line growth. Companies are operating leaner and more efficiently as cost cutting has led to strong profit margins over the last several years. But this becomes much more of a challenge over time and firms realize that they must grow the businesses in order to increase their profits. Thus, a hopeful sign would be to see corporate stock repurchases and dividend increases shift more toward spending on research, development and capital improvements.
- U.S. Economic Growth - As is often the case for sustained growth, consumer spending is key. Third quarter GDP growth of 4.1% was the second best quarter since before the recession and is a strong positive even as it is not expected to maintain that pace when fourth quarter statistics are announced. The new Fed chairwoman is hopeful for 3 percent growth in 2014. Rising consumer spending and accelerating job growth would likely be needed to attain this goal. Reasonably strong retail sales during the holiday season have fueled optimism that the U.S. consumer can remain resilient in 2014.
- Real Estate - The housing recovery continues, but rising mortgage rates may temper this growth into the current year. Year-over-year home prices rose by the most in the last seven years and new home starts were the best in the last five years. The supply and demand for homes is becoming more balanced and there has even been some tightness in construction employment. Mortgage rates, which are up about 1 percent over the last year, may dampen the improvement to a degree, but overall rates remain historically quite low.
- Fiscal Policy - Surprise reconciliation creates at least intermediate term stability. Perhaps the parties realized their approval ratings could go no lower, but whatever the reason, a surprise spending deal settles most fiscal matters at least until the eve of the next major election cycle. No grand bargain was achieved and many fundamental fiscal issues remain in terms of debt level and the expenditure impact of major programs like Obama Care. However, compared to recent crises, the agreements recently reached should at least have some calming effect on markets and hopefully, will be sufficient to allow continued economic expansion.
- European Economic Growth - Deflationary concerns threaten recovery seen in some euro zone areas. With consumer prices in the euro zone rising at their slowest pace since the onset of the financial crisis, worries remain that too little inflation, not too much, will sidetrack European and global recovery. This deflationary threat, which Japan struggled with for two decades and which is driving U.S. policymakers to extraordinary lengths, drove the European Central Bank to do the same and cut its key lending rate to 0.25%. An unemployment rate that remains above 12%, a relatively strong euro that makes exports less competitive, and banks reluctant to lend make it difficult for many businesses to get access to the capital they need to grow and further exasperate deflationary concerns. There are some positive signs, however, as retail sales in many areas are improving, as are budget deficits and trade surpluses in many countries.
The U.K. has experienced the opposite problem. Inflation has been outpacing the Bank of England’s target over the last several years. The latest inflation data shows, however, that consumer prices grew at a rate of 2% in 2013, reaching the Bank of England’s inflation target for the first time since 2009. Low inflation should allow monetary policy to remain loose in the face of faster than expected economic growth and shrinking unemployment.
- Asian Economic Growth - Asia continues to be the engine of global demand. Monetary and fiscal policies aimed at economic expansion appear to have shown some results as the Japanese economy grew faster in 2013 than in any year since 1996. This translated to a stock market that leapt by more than 50 percent in 2013, but still remains 58 percent below its peak level at the end of 1989. Investors are likely to focus on the sustainability of this economic growth in 2014, as much of the stimulus for the economy over the last couple of years has come from the government rather than the private sector.
Growth continues to slow in China, but remains strong on an absolute basis. China is estimating that its economy grew 7.6% in 2013, which would mark its third straight annual drop in the expansion. Rising labor and environmental costs continue to exert downward pressure on growth. Nevertheless, growth at this level for an economy the size of China’s remains impressive as it transitions from an investment driven to service driven economy.
Overall, most would agree that the state of the global economy is in significantly better shape than it was just a few years ago. Nevertheless, there is still the overhang of risk aversion and even seemingly small bumps in the road seem to cause considerable amounts of volatility and worry that the slow and fragile recovery will be derailed. With many equity markets near all-time highs, some investors seem to assume that a correction is inevitable. While this is of course always a possibility and inherent in equity investing, equities in general are hovering near average valuations. Furthermore, when compared to other investments such as bonds, a case can be made that equities are still favorably priced.
The possibility of higher interest rates also stands to influence equities as generally a rising interest rate environment may reduce stock valuations due to the steeper discounting of future earnings. However, increasing interest rates also generally reflect stronger economic expansion that may enhance profitability growth. Therefore, the investment policy we suggest avoids attempting to forecast interest rates or their impact on equity markets. Further, due to the multitude of factors that will bear on economic and market performance, our suggested policy specifically rejects trying to predict the nature and impact of such items. Instead, we would emphasize that investment policy development begin with planning and then rely on the time and diversification in its application.
Urban Financial Advisory Corporation
January, 2014