What an exciting year for U.S. equity investors! The 32% return of the S&P 500 was particularly surprising relative to the less than 2% growth in the U.S. economy last year. Returns were predominantly U.S. centric as the MSCI All World Index was up 22%, inclusive of the U.S. returns, and a more modest 14% as measured by the MSCI All World Index excluding the U.S. Though 4th quarter earnings are not yet in, consensus earnings growth for the year is approximately 5.5%, about half the 10% was predicted last January. Given these lackluster fundamentals, it is fair to say that the Federal Reserve’s policy of “easy money” accounted for much of the market’s success. The efforts by central banks to hold down interest rates in an effort to stimulate economic growth have actually pushed investors into equities in search of higher returns. Hence, it is no surprise that over 75% of the S&P’s return last year came from the willingness of investors to bid up the prices they pay for stocks (i.e. a price to earnings (P/E) multiple expansion).
Source: Crestwood Advisors
Though U.S. equities were strong in 2013, the Fed’s signal in June that it may begin to taper its actions made it a painful year for bond investors as most fixed income benchmarks ended the year in negative territory. The ten year U.S. Treasury started the year yielding 1.78% and finished just above 3%, a greater than 50% rise in yield which equated to a 7.7% decline in principal value. The Barclays Aggregate Index (the most commonly used benchmark) was also down over 2% for the year. For many bond investors this was their worst annual loss in nearly two decades.
As diversified global investors, we construct portfolios that can take advantage of diverging valuations throughout the world by selling relatively expensive assets in favor of building positions in those that may be out-of-favor for the moment. Our approach is grounded in the philosophy that constructing global portfolios allows investors to take advantage of lower-correlating investment opportunities that result in portfolios that are better positioned to provide more consistent long-term results. Over short periods of time, this approach can appear disproportionately disadvantaged when returns are dominated by only one asset class as was the case in 2013.
Importantly, investors need to consider not just their investment results, but also their tolerance for asset class volatility. Often investors have the tendency to extrapolate the recent past into the future without taking into account how the risks in the environment have shifted or, for that matter, how their own risk tolerances have not. For example, the best performing asset class over the last ten years, on a cumulative and annualized basis, is emerging markets. One need only look to the last twelve months of relative performance to appreciate why exposure to this asset class must be measured (see chart above).
Diversification, by definition, means investors will own multiple asset classes and short-term results will always lag the best performing investments in any single period. Furthermore, time & relative asset volatility help make clear the benefits of diversification. In 2013, the S&P enjoyed standout returns and has now not had a meaningful “correction” since the middle of 2011 versus an average intra-year drop of approximately 14% over the past 35 years.
This observation is not intended to convey that U.S. markets are tremendously overvalued and that a market correction is imminent as, unfortunately, we lack that crystal ball. Economic indicators are trending in the right direction with data on GDP, employment, housing prices and capital spending all pointing towards a gradually improving economy. Wall Street consensus has also turned more optimistic, predicting that the economy will expand 2.8% this year, an increase from the 2.5% estimate of a month ago and faster than the 2% expected for 2013.
Even with these positive trends, we remain keenly aware that the risks to the global economy and stock markets are still ever present. The greatest current unknown is how investment markets are going to digest gradual tapering by the Federal Reserve. This is an unprecedented event, and, even though the Fed has been transparent concerning its intentions, the uncertainty lies in the timing and unknown collateral consequences of these actions. Also, given the rise in U.S. equity markets last year, U.S. stock valuations are above long term averages, making them inherently riskier and, if history is a guide, implying more modest returns over the next few years. Profit margins also remain near peak levels and, though they appear stable given moderate labor costs, continued expansion seems unrealistic. Finally, disruptive geopolitical events always remain near the surface including the conflicts in the Middle East and the lack of clarity concerning China’s real economic growth.
Overall, we remain optimistic on U.S. equity markets but recognize that additional returns will require confidence in stronger earnings growth and potentially ongoing valuation expansion. Our portfolios remain overweight U.S. equities where our research efforts continue to unearth quality names with unique earnings opportunities, healthy balance sheets and compelling valuations.
Outside the U.S., we are taking advantage of specific European situations as well as emerging markets as they also show improving fundamentals and, given their performance divergence from the U.S. market, significantly more favorable valuations. Though Europe continues to wrestle with many social and economic problems, Germany and the UK have shown signs of economic progress with employment and industrial output exceeding expectations. As for emerging markets, we recognize that different geographies will have varying rates of recovery so targeting specific countries is critical. We have tilted our equity exposure within these countries to consumer-oriented names that are leveraged to rising incomes and an expanding middle class. Though our investments in these markets have struggled recently, we remain patient as earnings growth remains intact and valuations are close to 10 year lows versus U.S. markets.
After 5 years of artificially holding down interest rates, the policy shift by the Federal Reserve to taper their QE efforts will lead to moderately higher longer-term yields. However, unless we experience a significant acceleration in economic growth, we do not anticipate dramatically higher long-term rates in the near future. Historically, 10-year Treasury yields have tended to follow nominal GDP growth. Given that consensus GDP growth is forecasted to be 2.8%, the natural rate for 10 year Treasuries should settle somewhere between 2.75% and 3.25% (generally where they are now).
Though the Fed has signaled the beginning of the end of quantitative easing, they have also made it clear that they will remain accommodative as it pertains to short term rates and, given their goals for unemployment and core inflation, we anticipate this policy will be in place for years to come.
We believe some measure of fixed income exposure remains an attractive component of a diversified portfolio. We continue to favor high quality municipal or corporate bonds, complemented by exposure to mortgage debt, bank loans and sovereign emerging market debt to ensure diversification, limited duration exposure and a healthy income stream. Given the limited volatility in the equity markets over the last two years, bonds also provide an appropriate ballast to reduce overall portfolio volatility as well as a dry powder “reserve” to add to growth when appropriate.
Though gold has been a drag on recent portfolio returns, we also continue to believe a small exposure to the commodity remains prudent. Central banks and governments around the globe continue to run the printing presses in an effort to stimulate demand while debasing their currencies. Historically, these actions favor gold as investors look to it as a store of value to maintain purchasing power. Additionally, gold remains one of the true non-correlating assets to both bonds and equities and provides some portfolio insurance during volatile environments.
Overall, our economic outlook for 2014 remains cautiously optimistic and we anticipate that we will have chance to continue to add to equity positions throughout the year as opportunities present themselves.