2014 Outlook: Back to Normal
In 2013, the U.S. equity market experienced its best year in well over a decade. The Dow Jones Industrial Average was up 26.5%, the largest annual gain since 1997. Anything with a hint of equity beta did well in 2013, as the tailwinds from the market continued throughout the entire year. The bond market experienced its worst year since 1994, and its first negative year since 1999, as the market became concerned that the U.S. Fed would taper its quantitative easing program and force interest rates to rise. The Barclays Aggregate Bond Index was down 2.1% for the year. The 10-year Treasury rate increased from 1.76% at the beginning of the year to 3.03% at year end.
So where do we go from here?
Equity market returns notwithstanding, 2013 will likely be looked back on as the turning point in which the global economy moved on from the continued state of global crisis which began in 2008 and back toward sustainable recovery. While unprecedented easy monetary policies were still in effect at 2013 year end, the Fed and other central banks have begun to reduce or consider reducing their accommodative policies.
Against this macro backdrop, our asset class weightings suggest a return to more normalized market conditions. There will be headwinds facing particular market segments, however our allocations reflect a market environment which will return back to a focus on economic data, company fundamentals, and earnings growth. 2014 will not be a repeat of 2013, and investors must be mindful of the potential effects that central banks actions will have on global markets.
Investment Themes for 2014:
Focus on developed markets over emerging, with a particular emphasis on U.S. large cap and European stocks.
We believe developed market equities can perform well this year. While we do not expect similar returns from 2013, we think that corporate earnings will accelerate in the second quarter leading to high single digit returns for year. At this stage in the market cycle, U.S. large caps should outperform relative to smaller cap companies. In foreign developed markets, European equities are attractively priced and most of the banking issues have dissipated. In emerging markets, as tapering continues, the strengthening U.S. Dollar will exacerbate issues in nations with problem currencies, evidenced by the issues Argentina and Turkey have experienced year to date. Additionally, as China shifts its focus to structuring policies to spur domestic consumption, Chinese GDP growth will slow. This creates potential issues for peripheral Asian nations.
Japanese equities present a unique opportunity as the government maintains strong interventionist policies.
In 2013, Japan’s new Prime Minister Shinzo Abe instituted an unprecedented level of monetary easing coupled with increased government spending policies which have been labeled “Abenomics”. The new policies helped generate the highest level of inflation Japan had experienced in 14 years. Additionally, the Nikkei appreciated 57% and the Yen depreciated 18% relative to the U.S. Dollar. While Japanese equities have experienced a correction early this year, we think the Bank of Japan will continue its accommodative policies through 2014 and that Japanese equities will appreciate as the Yen continues to depreciate.
There will be significant headwinds to emerging markets (EM) this year, but active management should be able to uncover pockets of growth in the frontier markets.
Since the U.S. Federal Reserve signaled last May that it would start scaling back on debt purchases, the emerging market equity index has lost over 10% while the S&P 500 has gained over 10%. It is important to understand that not all EM countries are the same. EM nations are incredibly diverse in terms of income levels, political climate, and financial sector development. A segment of EM we like is frontier nations. These countries are generally less developed and may have less dependency on more developed nations for growth. We favor frontier markets with strong domestic consumption growth, attractive demographics, and improving policy and reform agendas. In such a fragmented market segment with such idiosyncratic risks, we favor active management in order to mitigate these risks.
Given the interest rate environment, we will overweight non-traditional fixed income and emphasize illiquid credits, private distressed debt, and unconstrained bond strategies.
Over the last few years as rates have fallen to historic lows, the liquidity premium on private debt versus public debt has become significant. Additionally, the default premium placed on illiquid and distressed debt appears outsized. Compared to traditional corporate debt and bank loans, private and distressed credits are attractive. Unconstrained bond strategies are also a way to limit interest rate exposure while maintaining diversified exposure to traditional fixed income sectors. Unconstrained bond strategies have the ability to shorten (or even go negative) bond durations, an advantage if interest rates rise.
We will continue to transition a portion of our fixed income allocation to uncorrelated hedge fund strategies.
The 30-year bull market in bonds likely ended the week of April 29th last year when a better than expected jobs report all but assured that the Fed would begin to taper its quantitative easing program in 2013. We expect long-term rates to rise gradually over the next few years. Given the headwinds facing fixed income in a rising rate environment we will continue to shift a portion of our more defensive allocation in our portfolio to conservative, low-volatility hedge fund strategies.
In our real asset portfolios we will focus on income producing assets, such as real estate, oil pipelines, and drilling well, placing less of an emphasis on commodities and hard assets.
Given the macro trend of slowing growth in emerging markets, we will continue to underweight traditional commodities. By comparison, we think there is opportunity in income producing hard assets, such as REITs, MLPs, and upstream energy. While these asset classes can be volatile, they provide diversification benefits and an income component to the portfolio.
EQUITY MARKET OUTLOOK
Market fundamentals indicate that equities still have room to grow in 2014, but we do not expect returns to be as impressive as last year’s. We expect U.S. equities will return 7% to 10% this year, driven by the liquidity provisions of the Fed, corporate investment, an improving housing market and modest economic growth. Although tapering should affect the markets over the long term, they remained relatively stable after the Fed announced that it will taper its bond buybacks in 2014. Tapering will take some time, and new Fed Chairwoman Janet Yellen has indicated that she intends to continue supporting the economy even after the Fed’s target unemployment rate is achieved. Knowing that the tapering program will be drawn out should boost the confidence of the banking and corporate sectors to increase lending and private investment, respectively.
Foreign Developed Equity
In other developed economies, we expect moderate economic growth throughout the year. Japan has done an outstanding job of implementing the first two stages of “Abenomics”. In 2013, the country produced strong growth and core inflation rose to its highest level in 15 years. The success of Prime Minister Abe’s strategies incited a spectacular run in Japanese equities that we believe can continue in 2014, albeit at a more moderate pace. We have increased our exposure to Japanese equities for 2014 based on these expectations. Abe has shown little indication of throttling back his QE program, and the economy should continue to benefit from a stronger U.S. dollar, European growth, and a weaker Yen. Although the long term effects of Abenomics are yet to be seen, we do not expect a dramatic increase in volatility during the year.
Europe has emerged from recession and appears well positioned for economic growth moving forward. Valuations are at reasonable levels across the area and should continue to remain subdued as moderate growth continues. Companies could benefit from a cyclical recovery and M&A activity is expected to increase as companies begin investing excess cash. The exit from the recession, the continued oversight by the ECB and the return to growth has helped decrease volatility in many of Europe’s major markets. Although the recovery has been slow, corporate earnings are expected to increase this year. We are taking a cautiously bullish stance on European equities and have adjusted our allocation take advantage of the attractive opportunities in this region.
Emerging markets (EM), relative to developed market equities, experienced one of their worst years in history in 2013. Many countries struggled to increase growth amidst a world of decreasing commodity prices, central bank intervention, and strengthening currencies in the U.S. and Europe. We expect many of these headwinds to persist this year. Additionally, 2014 is an election year for many EM countries. The effects of these elections remain to be seen and could potentially damage market sentiment toward EM economies. In 2014, we will continue to allocate to frontier markets, as we believe they are in the early stages of a potentially long-term investment cycle. High GDP growth and favorable demographic trends make this area attractive. Eastern European countries and Mexico appear to have the best growth prospects for 2014 and should benefit as the U.S. and European economies continue to improve.
The global economy is moving in the right direction, but there are still many risks that could render uncertain negative effects on the markets. The recent announcement to taper QE did not have a large effect on the market, but a flaw in the Fed’s exit strategy could cause problems and mitigate recent economic gains. Japan is in the midst of the largest QE program ever attempted, and although the results have been positive so far, the long term effects can only be speculated. Europe has faced headwinds from high unemployment and weak credit growth. Europe has struggled with bank reforms, and the ECB will most likely need to continue supporting central banks which could generate a culture where it is ok to fail. The risks in Emerging Markets could continue to be exacerbated by weakening domestic currencies, low commodity prices and regulatory uncertainties following elections. We do not expect the aforementioned risks to have extensive negative effects on our positions in equity markets this year, but we will monitor the global macro landscape and be prepared to actively manage the risk factor of our portfolio.
FIXED INCOME OUTLOOK
US Fixed Income
In the U.S., interest rates are expected to remain low this year as the Fed tapers its bond purchases but remains focused on economic growth. Fixed income risks may be accentuated if income does not rise with interest rates, therefore, we are leery of U.S. bonds, Treasuries and TIPS. Our views are slightly more positive toward investment grade corporate debt and municipal bonds. Investment grade should generate modest returns with minimal volatility, and municipal bonds offer higher returns than treasuries and include attractive tax benefits. Look for rates to begin rising at a faster pace when the PCE inflation index reaches or surpasses 2%. We expect 10-yr rates to increase to somewhere between 2.8% and 3.3% during 2014.
International Developed Fixed Income
In international developed markets, the ECB should remain accommodative as Europe enters a stage of slow growth. Rates should begin to stabilize at depressed levels during 2014. The UK has been recovering quicker than the rest of Europe and should see rates following a path similar to the U.S. In Japan, there may be a small rise in rates if inflation continues to rise, but extremely accommodative policies are expected to keep rates low. Although, if the BOJ is not able to depreciate the Yen further, rate will rise causing yields to contract.
Emerging Markets Fixed Income
Few enticing opportunities are present in emerging market debt for the amount of risk present. Fundamentals in emerging markets are attractive, but currency depreciation is a major risk and has already been a factor in 2014. Also, rising rates in developed markets are a headwind to EMs and could cause inflation to jump, intensifying a currency crisis. Lazard projects returns on EM local currency and corporate debt to be between 7% and 8%. Although these returns are higher than those expected for developed markets, we do not believe that reaching for yield and increasing portfolio volatility is justified in the current risk environment.
Given the level of uncertainty in the fixed income landscape, we recommend taking a patient approach to fixed income by utilizing diversified bond mutual funds and bond ETF’s. This allows investors to reinvest when rates rise and decreases portfolio volatility.
The U.S. is currently suffering from a real estate supply problem. The sluggish economy following the financial crisis suppressed housing purchases and construction. Recently, the U.S. economy has shown resilience, and we expect economic growth to continue in 2014. The real estate market offers many attractive opportunities for outperformance. Historically, housing has constituted around a 5% portion of GDP growth, but it is currently below half of this value. Housing demand has increased over the past year and is driving the market back to this GDP trend. Demand should also be facilitated by the low interest rate environment. Construction and home sales need to be increased to meet the current demand. On the commercial side, many companies have experienced top-line growth and have cash that they have been waiting to use until new regulations have been implemented. We expect many companies to enter growth and expansion phases in 2014 which should be a catalyst to commercial real estate growth this year.
Internationally, our real estate outlook is slightly negative. We do not see many opportunities this year in Asian-Pacific countries. Recent reports indicate an economic slowdown in China and it has continued to struggle with its banking sector problems. Europe offers some attractive valuation metrics for real estate with the U.K. market leading the way. Although the valuations are positive, the muted growth of the region does not bode well for increased consumer or corporate spending on real estate.
Overall, real estate appears to offer fairly valued opportunities that should produce returns over the long-run. We recommend that investors use real estate as a long-term position in their portfolios.
HEDGE FUND OUTLOOK
During 2013, HFRX Aggregate Index realized a 7.40% return. Short strategies, managed futures and global macro lost money in 2013. Long/short equity, long only and more directional strategies generated the highest returns. Headlines showed that hedge funds underperformed the market for the fifth consecutive year on an annualized return basis given a return of 18.7% for the S&P 500 last year, but investors must interpret these performances based on the risk taken to achieve them. The volatility of the S&P 500 measured by the VIX fluctuated between 11.05 and 21.91 while hedge fund volatility over the same time period was between 4% and 5%. For the risks incurred by the investor, hedge funds generated a healthy return.
The quick acceleration of equity markets has driven many investors into alternative assets. The hedge fund industry saw assets peak at $2.5 trillion in 2013. A driving factor of fund inflows is hedge funds ability to protect upside gains and avoid the perceived risk of a market correction or rising interest rates. The positive run in equity markets and the announcement of QE tapering during 2013 set the stage for a considerable market correction in the near future. Also, the market is currently on the back end of a business cycle. Alternative investments benefit as business cycles end because of their ability to participate in market upside while providing downside protection. Another advantage of hedge funds is their capacity to operate as a substitute for fixed income that nullifies interest rate risk. The current projection of increasing interest rates over the next few years lends merit to increasing allocations to hedge funds, and we have adjusted our model portfolio to reflect this.
Looking forward for 2014, many hedge fund strategies are well positioned to take advantage of the future economic environment. Long-short equity, distressed, global macro, managed futures and multi-strategy funds are all capable of generating strong returns while maintaining a low volatility profile.
2014 is poised to be a good year for the private equity (PE) market. Over the past few years, the Fed’s expansionary monetary policy has provided companies with readily available and affordable financing. As a result, M&A activity is expected to accelerate, and market competition should remain strong. Market insiders expect PE transactions to enter an upcycle this year as recessionary headwinds continue to diminish. Direct investments are expected to increase, driven by the record amount of AUM held by PE firms and new regulations that allow pension funds to deploy up to half of their capital into co-investments. The increase in PE activity should result in increased distributions to LPs during the year. The PE industry should also benefit from current shifts in bank’s lending practices. Regulatory changes have increased traditional banks’ cost of lending to small and mid-size businesses. This has forced middle market and small business to become increasingly reliable on PE financing and has created investment opportunities for business development companies.
Throughout 2014 we do not expect managers to able to ride the market increase wave as many did in 2013. Historically, manager selection has been the most important factor in determining the success of a PE firm. We believe that our private equity investments will be strengthened by our ability to identify managers and firms that have proven results and focus on the quality of their investments.