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 global growth.
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 commodity prices.
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.