AOTW 2013 0111

Outlook & Strategy

By Sam Sweitzer, CFA                                                                                                      January, 2014
A Look Back at 2013 and Strategy for 2014

2013 turned out be the best year for the US stock market since 1997. The year began with investors focusing on a myriad of risks, including government budget stalemates, European debt, and interest rate hikes. Reasonable corporate profits, benign inflation, and massive quantitative easing pushed the S&P 500 up nearly 30%. The economic recovery continued and interest rates rose moderately (not withstanding a mid-year jolt). International markets notched up significant gains as well. The Japanese Nikkei rose by an meteoric 57% and the German DAX rose by 25.5%. Yet Emerging Market indices were the outlier, struggling with uneven growth and structural imbalances.

Having seen stock markets rise strongly during the year, many investors are dissatisfied with the ‘mediocre’ returns of a diversified portfolio. In fact, a portfolio of 60% global stocks and 40% bonds, earned a paltry 15.97% in 2013, only 1/2 the return of the S&P 500. Herein lies the a misconception with diversified portfolios. They are not intended to ‘beat the market’, but rather earn returns gradually. In rapidly rising markets, they will trail stocks. But in falling markets, they can offer better preservation of capital.
As we enter 2014, many investors are considering increasing their allocation to stocks. We must caution against such a move, as it is most likely caused by a behavioral issue known as ‘recency bias’. Recency bias theory postulates that investors weight the effects of events in the near past more than the effects of events further in the past. Stated in plain English, investors tend to drive by looking in the rearview mirror. Before an investor considers increasing his or her allocation to stocks, consider the graphic below:
Although a balanced portfolio of 60% stocks and 40% bonds earned only 1/2 the return of ‘the market’ in 2013, a longer view reveals the prudence of holding diversified portfolios. Had an investor held a diversified portfolio, he or she would have had more wealth than an investor who only held the S&P 500. In fact, it took over five years for a the S&P 500 to catch a diversified portfolio after the crash of 2007-08.
Diversification is boring, but it works.

2013 was not a great year, on a relative basis, for our discretionary portfolios at Anson. Our portfolios entered 2013 heavily weighted toward International and Emerging Market stocks. We were underweight US stocks primarily because objective historical data showed them to be overvalued. Although our portfolios performed much better during the second half of 2013, our first half was disappointing.

Strategy for 2014— Equity markets in the US appear more likely to experience a year of validation more than appreciation in 2014. To sustain the gains of 2013, markets must see significant economic growth both in the US and abroad. Investment returns in 2014—for both stocks and bonds—will also be driven by the actions of central banks in the US, Europe, and Japan. For the first time since the current economic recovery began, the world is experiencing synchronized recoveries in the US, Japan, and Europe. By far, Europe’s recovery is the most fragile and Japan’s is based on the most relative monetary stimulus, but should economic growth accelerate in 2014, returns should be solid. From a broad perspective, investors may feel a sense of deja vu about our strategy for 2014. We expect many of the macro factors that existed in 2013 to continue in 2014. We believe US economic growth will pick up slightly from 2% real growth to 2.5%-2.75% real growth. We expect global growth to also increase slightly from 3% to 3.5%. Although the Fed has indicated that it will begin tapering quantitative easing during 2014, their overall policy will remain accommodative and supportive of economic growth. Slightly better economic growth should lead to higher real interest rates. We do not believe interest rates will rise rapidly, but yields are likely to climb modestly, with the benchmark 10-year US Treasury bond ending the year around 3.0% to 3.50%.

US Economy

Employment—The labor market continues to improve gradually. Job gains averaged 200,000 per month over the final three months of 2013. Much of this was driven by cyclical improvement in private sector hiring. The manufacturing, construction, and retail sectors all hired more workers in late 2013. Small businesses also increased payroll. The US labor market remains in a steady upturn, which is a leading indicator for solid economic growth.

Inflation— Inflation remains well anchored with small increases in core inflation (1.7%) since last April and should continue through early 2014.
This very modest inflation counterbalances the growing disinflationary trends in Europe. If wage growth picks up here in the US, inflation could also move higher. This is a potential inflationary pressure to be watched closely. Although the US may see inflation increase slightly during the latter half of 2014, this trend should not pose any significant threat to economic growth.

Consumption— Consumer activity in the US has been modest throughout the current recovery. Core retail sales have averaged 3.9% annualized growth over the past year and should remain in a similar range for 2014. Households have been supported by a low interest rate environment, which has provided affordable credit for durable goods and helped reduce the ratio of financial obligations payments to disposable personal income to near the lowest level on record. Even during the government shutdown in the fall, consumer confidence fell less than anticipated and spending remained relatively constant. Real wage growth has remained elusive in this economic recovery. A sustained increase in real wage growth would signal that the US economy is finally reaching escape velocity and the recovery could accelerate. Our best assessment is that wage growth will remain tepid during 2014 and confidence measures will remain steady, but not stellar.
Credit and Banking—Although credit conditions are generally accommodative and supportive of economic growth, most of the money created by the Federal Reserve through quantitative easing has not ended up as loans to small and medium sized businesses. This lack of significant lending growth has stymied economic expansion. Both the Federal Reserve and the European Central Bank have commented on this issue and it remains a central roadblock to faster economic growth. Although banks are reporting loosened lending standards (via the Senior Loan Survey from the Fed), loan growth to businesses has basically stagnated. Adding further pressure, the rise in interest rates since last May has made some investment projects unprofitable for corporations. As interest rates rise, the required rate of return on any project or investment must also increase in order to overcome the higher interest costs. Although credit is accommodative, the lack of loan growth could be troubling.
Housing—During the early part of 2013, the housing market recovery was robust. However, since interest rates spiked in May, the housing market re-covery has slowed. Supply and demand data show a largely balanced market, but with home prices up 13% over the past year and mortgage rates almost a full 1% higher, house prices may not appreciate as rapidly in 2014. Affordability has dropped, although it is still near all-time highs, sales activity has slowed, and the housing market is likely transitioning from a period of fast-paced recovery to a more mature housing expansion.

Corporate—The corporate sector remains a bright spot for the US economy. Manufacturing has steadily im-proved and profitability has remained high. Purchasing Managers’ Indices for both manufacturing and services show solid growth. Capital expenditures by corporations have remained low. Policy uncertainty, regulatory changes, government shutdowns, and lingering concerns from the 2007-08 recession have pushed corporations to remain conservative with expansion. If capital expenditures grow significantly in 2014, this would be a very positive sign for the US economy.

Global—The global economy continues to exhibit modest improvement with cyclical progress in Europe and Japan driving most growth. Leading indicators have improved over the past nine months in approximately 3/4ths of the world’s largest economies. In fact, 82% of economies (including the US) are now seeing manufacturing activity increase.

Europe—The EU is exhibiting increasing divergent economic paths in member countries. While Germany has seen solid growth as of late, France’s economy has slid back into recessionary territory. The U.K. is also experiencing a solid recovery, but nations such as Italy and Spain remain mired in structural weakness.

Japan—Japan’s economy is now firmly in mid-cycle expansion. The Bank of Japan’s massive monetary stimulus effort is beginning to raise the country out of deflation, and this is a positive sign for economic growth. Japan’s manufacturing sector is seeing growth; its labor market is improving; and Japanese companies are seeing stronger profits driven by bolstered exports. Yen weakness has contributed to all of these domestic improvements in Japan.

China—China’s policymakers are attempting to balance stable growth with tame inflation. Both credit expansion and housing prices are rising too rapidly and this threatens the very stability of China’s entire financial system.

Emerging Markets—The majority of emerging market economies remain in expansionary mode. Structural challenges abound, but productivity is high and emerging markets remain a bright spot in global stock market valuations. Brazil, India, and Indonesia all face the specter of stagflation. Rising current account deficits and rising inflation are being met with increased interest rates. If these large emerging economies raise local interest rates too rapidly, economic growth may lose momentum.
Risks to the Global Economy in 2014

US—Perhaps the greatest threat to the US stock market is that the growth forecast by 2013’s 30% equities rise does not pan out. If economic growth disappoints and investors conclude that Fed monetary policy has reached its limits, then much the gains of 2013 could be lost. The equity market gains in 2013 largely reflected investor confidence that the global economy—and particularly the US economy—is returning to more normal growth rates. US economic growth between 2.5% and 3.0% in 2014 will be needed to validate those market gains. If GDP growth disappoints, US markets could correct. US Equity markets are near the top of their valuation ranges and bond yields are still relatively low. Investors are currently rotating massive amounts of money from bond funds to stock funds. If GDP growth were to weaken, a 10% to 20% correction would most certainly ensue. The US market has not seen a 10% correction in equity markets for over two years. It would not be surprising if markets did not pull-back at some time during 2014.

Europe—Although Europe is beginning to exit its double-dip recession, euro zone risks are still high. In some countries, deflationary forces are gathering strength. European banks are weak and their connection to governments is toxic. Credit growth is slowing and a return to recession cannot be ruled out. Sociopolitical risk is also high in Europe. In Greece, Communism is on the rise. In the rest of Europe, extremism remains a real threat. Europe still needs greater structural reforms and peripheral European countries remain stuck in a debt trap.

China—China must balance monetary tightness with the disruption of reforms. If this delicate balance is not maintained, China’s growth target of 7-8% GDP growth could falter.

Japan—Market expectations for Japanese GDP growth are only 1.6% for 2014. Although this seems very reasonable, Japan is still in the midst of major structural reforms. The implementation of a higher consumption tax in April could pose real challenges to Shinzo Abe’s reforms. The major risk to Japan is that the Bank of Japan’s aggressive monetary policy will spark inflation but fail to bring real economic growth. If this happens, the hugely indebted country could see a collapse in confidence in both its stock and bond markets.

Conclusion—The signs of economic healing in Europe and Japan, along with an improved growth outlook for the US, should keep equity markets moving slightly upward this year. We do not expect 2014 to be a repeat of 2013, where the US market marched upward uninterrupted. Fits and starts will mar 2014’s markets, which means increasing volatility on the way to slightly higher markets. Japan’s tax policy changes are significant, as is Europe’s risk of deflation.

Economic data show that the recovery in Europe is taking hold. Less austerity should provide a tailwind for growth in peripheral countries. The ECB should provide support where and when it can. Valuations are still relatively attractive and trade is turning into a formidable growth engine.

Emerging Markets stand out as a clear value opportunity in 2014. Uncertainties over China’s credit situation and the impact of US Federal Reserve tapering should make investors cautious to jump into Emerging Markets too early. Nevertheless, Emerging Markets as a whole are undervalued. The prospect of increasing export demand from developed economies and the rise of the local consumer will likely fuel growth for years ahead. Emerging Markets represent a good long-term investment opportunity for the patient investor.

We anticipate that global equities will outperform cash and fixed income over 2014, but not by the margin of 2013. Volatility in stock markets is also likely to return. The Fed will likely begin the process of withdrawing quantitative easing during the year and the effects of this represent uncharted waters. 2014 will not be a set-it-and-forget-it year. We’ll be watching economic data closely and responding in ways that seek to maximize risk-adjusted returns.
This newsletter is a publication of Anson Capital. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.
Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information on products and services. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's portfolio.
Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended by the adviser), will be equal to past performance levels.
Anson Capital is registered as an investment adviser with the SEC. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements.
Information presented is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.

Anson Capital, Inc.  Atlanta—Charleston, (678) 216-0795,
For comments or questions, please contact: Sam Sweitzer at [email protected]
Copyright 2014, All Rights Reserved
Sam Sweitzer, CFA │Principal│ANSON CAPITAL, INC.
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