Robert C. Doll, CFA
Chief Equity Strategist, Senior Portfolio Manager
Nuveen Asset Management, LLC
Confidence Begins to Return, Lifting the Economy and Equities
Beginning the year without major clouds on the horizon, we are encouraged
by a strengthening global economic recovery. Fed tapering represents a belief
in stronger economic conditions but also a possible source of volatility. Central
banks remain committed to monetary reflation. We anticipate economic
power and financial wealth will continue to shift from developed countries to
emerging markets that we believe now set the pace for
The U.S. economy grows 3% as housing starts surpass one million and private employment hits an all-time high
After several false starts, the economic recovery that started in mid-2009 will likely
show some broader and stronger growth in 2014. Hopeful signs include: housing
recovery, falling oil prices, acceptable job growth, easing lending standards, low
inflation, very high net worth, rising capital expenditures, less fiscal drag and improving
non-U.S. growth. These forces should result in stronger housing starts and an all-time
high in private employment. However, obstacles to growth also exist: high levels of
uncertainty, continued high unemployment, mediocre real wage growth, a low savings
rate, declining refinancing and the potential for prolonged deleveraging.
10-year Treasury yields move toward 3.5% as the Fed completes tapering and holds short-term rate near zero
We expect the bear market in bonds will continue as interest rates slowly normalize.
While the Fed has indicated it will keep policy rates anchored close to zero, the long-awaited
tapering process should be completed during the year. The inflation rate is a
big question for the bond market, economy and overall markets. Inflation is not likely
to rise significantly, and it could make a bottom by the end of 2014. From a very low
level of interest rates, not much capital depreciation in bonds (caused by rising rates) is
required to offset coupon earned, with the potential for negative total returns for
many parts of the fixed income market.
U.S. equities record another good year despite enduring a
After very strong performance in 2013, equities may have already taken 2014 returns.
Accordingly, while we think equities can experience further upside, we expect
gains to be less ebullient and more volatile. With the significant rise in valuation levels
(P/E ratios) in 2013, we expect that market gains will depend more on earnings growth
than further multiple expansion. Expectations of high single digit or low doubledigit
gains are not unreasonable, but we also think a noticeable pullback is likely to be
caused by overbought and deteriorating technical conditions. We would use corrections
as buying opportunities since most fundamentals continue to improve.
Cyclical stocks outperform defensive stocks
After a long run of defensive stock leadership, cyclical stocks asserted themselves in
2013. For earnings and valuation reasons, we expect cyclicals to continue to outperform.
Cyclical sectors include consumer discretionary, energy, financials, industrials, materials
and technology. Defensive sectors include consumer staples, healthcare, telecom,
and utilities. Stronger U.S. economic growth, a rise in capital expectations and some
improvement in non-U.S. economies should also support this conclusion. When
analyzing companies, we currently prefer free cash flow yield to dividend yield and
dividend growth over dividend yield.
Dividends, stock buy-backs, capex and M&A all increase at a double-digit rate
Corporations have amassed high levels of cash, with strong cash flow, and may have
underleveraged balance sheets along with potential places to use the cash. With reduced
uncertainty and improving confidence, we anticipate that more cash will be “put to work”
in 2014. As a result, we think dividends, share buy-backs, capital expenditures and
mergers and acquisitions will experience noticeable increases. Dividends and buy-backs
have been increasing in recent years, but we expect surplus cash to spread to businesses
reinvestment (capex) and buying the company “down the street.” Pent-up demand and
aging facilities, equipment and technology also argue for increases in these key areas.
The U.S. dollar appreciates as U.S. energy and manufacturing trends continue to improve
Currency direction is one of the most difficult areas in the capital markets to get right.
Along with improved and broadened growth, as well as technical support, we believe
the developing U.S. energy and manufacturing stories are positive for the dollar. An
abundance of cheap natural gas and increasing energy production is already providing
a positive impact on the U.S. trade deficit and promises to enhance U.S. job additions
and economic growth. Increasing desire by U.S. and non-U.S. companies to manufacture
in the United States for labor, cost, infrastructure and stability reasons has a similar
constructive dollar impact.
Gold falls for the second year and commodity prices languish
In our opinion, the mystery is not that gold finally came down but rather that it took so
long. The preoccupation with gold was originally based on concerns about the viability
of the financial system and inflation fears from excess liquidity being pumped into the
system. Neither of those circumstances occurred, but gold traded above $1,500 per
ounce before falling last year. Now, added headwinds put pressure on gold’s allure—
improving global growth, a reduction in systemic threats, some rise in real interest
rates and likely dollar improvement. Also, the lack of strong global economic growth
and abundant supply for many commodities argues for trendless but relatively volatile
Municipal bonds, led by high yield, outperform taxable bond counterparts
Municipal bond mutual funds experienced record weeks of outflows
in 2013. And while municipal fundamentals are arguably mixed, our contention is that
the pricing of municipal relative to taxable fixed income securities more than
take that into account. Rising interest rates (prediction #2) create a headwind for fixed
income, but we believe the tax-exempt market (especially high yield) is positioned for
outperformance. The difficulties in Detroit and Puerto Rico have created an interesting
opportunity for municipal bond investors. We believe the fall of 2013 was a turning point
for state and local governments as politicians and unions began to agree to certain
reduced pension benefits. Government receipt and outlay patterns also improved.
Active managers outperform index funds
Recent years have been disappointing for active managers’ abilities to outperform
benchmarks. With the broadening of the equity market and the reduction of
correlations, the ability of active managers to outperform may increase. Whether or
not the number of managers outperforming crosses 50% is debatable, but support for
that outcome seems to be increasing. As cheap stocks outperform expensive ones and
companies with improving fundamentals outperform companies with deteriorating
fundamentals, active managers have a better chance to outperform. A reduction in
the number of active players may also reduce the competitive landscape somewhat.
Republicans increase their lead in the House but fall short
of capturing the Senate
Washington, D.C., was front and center in 2013 with mixed consequences. We believe
a dovish Fed and declining federal budget deficit make the Washington
backdrop at worst benign and more likely constructive for investors. The “small ball” deal between Democrat Patty Murray and Republican Paul Ryan
will likely reduce the negative focus on fiscal policy. The November mid-term elections
will soon dominate, with the likelihood of Republicans slightly increasing their lead in
the House of Representatives, and increasing representation but failing to control the
Senate. Other key issues may include the improved economic outlook, fiscal
restraint, Obamacare and the loss of global prestige.