An editorial opinion
by Troy Frerichs, CFA®
Director of Investments - Wealth Management
January 3, 2014
Wow! 2013 ended one of best all-time years in stock market history, with the S&P 500 up 32.4% on a total return basis, the fourth highest annual return since 1960. The equity markets have continued to climb the proverbial “wall of worry” over the past five years and the S&P 500 is sitting at all-time highs with a total return nearing 200% since the March 2009 market lows. On the opposite end of the spectrum, fixed income investors had a challenging year. With Federal Reserve actions and stronger economic results, the U.S. 10-year treasury yield increased from 1.7% at the start of the year to 3.0% at the end. As a result, the Barclays U.S. Aggregate Bond Index decreased 2.0% for the year. Looking to 2014, the stage appears set for more normal returns in the stock market and for continued challenges on fixed income investments as interest rates continue to normalize.
The most discussed subject of 2013 revolved around the Federal Reserve (Fed) beginning to “taper” its bond purchases or Quantitative Easing program (QE). The latest iteration of the Fed’s large- scale asset purchase program had it buying $85 billion per month in treasury bonds and mortgage-backed securities. This led to a Fed balance sheet that has grown from $800 million in 2008 to almost $4 trillion today.
We expected the Fed to begin to taper in September, but they held off ahead of the political uncertainty surrounding the October budget and debt ceiling debates. While the federal government did shut down for 16 days at the beginning of October as Democrats and Republicans wrangled over budget priorities, the damage to the economy was manageable. Given the negative public reaction associated with the government shutdown and debt ceiling standoff, it seems less likely that congress will venture so close to the edge again during an election year in 2014.
With improved confidence in the political backdrop, the Fed finally decided in mid-December to move forward with the initial tapering of its QE program. The central bank will start by reducing its bond purchases by a modest $10 billion per month. Adding even more qualitative statements to its commentary than usual, the Fed emphasized that it will keep short-term rates near zero until the unemployment rate is well below 6.5% and inflation is greater than 2.0%. How quickly the Fed terminates QE completely remains an open question. The strength of incoming data on the economy will remain the trigger.
While economic growth here in the U.S. has been regarded as below average since the Great Recession ended in June of 2009, there are signs that Fed intervention is no longer required. Some of the headwinds that presented themselves in 2013, like spending cuts and government shutdowns, don’t appear to be the base case for 2014. Consensus estimates for 2014 are calling for GDP growth of 2.6%. This seems reasonable to us given the strength that has been seen in the U.S. private sector.
The U.S. private sector has several notable tailwinds behind it: the job picture is improving, housing remains strong, household net-worth is at an all-time high, balance sheets have been repaired, interest rates remain historically low and inflation is tame. As a result, private sector confidence is on the rise.
Business capital expenditures as a percentage of GDP still remains well below historical levels, but this should start to change. Capital spending will be needed to support increased sales both domestically and abroad. Corporations are flush with cash right now and capital spending increases could very well be in store for the U.S. economy in 2014.
The economic backdrop continues to be supportive of stocks. Better economic results should translate into accelerating corporate earnings growth and thus continued momentum in the equity markets. It should be noted, however, that in the aggregate, stocks are no longer considered cheap and are close to their historical average valuation levels. Thus a repeat of 2013 performance shouldn’t be expected. It is interesting to note that the average annual total return of the S&P 500 since 1960 has been 10.6%, yet the market has only produced four years out of the last 53 that have had total returns between 8% and 12%. We continue to plan for uncertainty and know that proper asset allocation, diversification and security selection remain key elements to any well-designed investment portfolio.
Over the long-term, the 10-year treasury yield has averaged about 2.6 percentage points above inflation. Adding 2.6% to today’s inflation level would get the 10-year to a yield above 4%. So ultimately, it is difficult to argue that rates still aren’t poised to rise from here. However, given that global economic growth still remains challenged, we will most likely see 10-year yields rise remain below 4% in 2014. However, with Fed tapering and improving economic results, rates could move into the mid-3% range. This type of move will ultimately limit the return available in bonds as price declines (there is an inverse relationship between bonds prices and interest rates) offset interest income (yield) received from the bond.
While we still prefer the risk reward in equities relative to fixed income heading into 2014, we believe the risk-averse investors are well served with some level of fixed income securities in their portfolio. Even in rising interest rate environments, bonds have historically shown the ability to improve risk-adjusted returns when coupled with equities in a portfolio. This is due to the diversification benefits derived from bond returns having low correlations with stock returns over time. To put it another way, bonds have historically acted as a shock absorber in a portfolio.
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