Still Positive but Expect Volatility in 2014
After a weak start to the year which was exacerbated by geopolitical tensions surrounding Russia’s annexation of Crimea, global markets rallied in March. While there was considerable differentiation throughout the quarter, in aggregate, global equities were able to post modest gains. Somewhat surprising, and inconsistent with our longer term strategic perspective, was that bonds, specifically U.S. Treasury Bonds, also rallied and were among the best performing asset classes in 1Q 2014. In many ways, 2014 has begun the way 2013 ended, but don’t expect a repeat of last year’s performance.
As we’ve been communicating to clients, we expect most of 2014 to deliver positive, if rather muted returns with an increase in volatility. This is despite an overall economic backdrop that may well prove stronger and more self-sustaining than over the past few years. We experienced unusually strong returns, specifically from domestic equities, in 2013. Essentially, a good portion of 2014 will likely need to be considered in the context of 2013’s success.
We remain strategically positive on global equities and do not anticipate major portfolio allocation changes at this time. It is worth noting that in the context of a rising interest rate environment, we have been diversifying our fixed income holdings and reducing traditional, more interest rate sensitive bonds with hedged, low correlation alternative investments.
The rest of 2014 can’t escape 2013’s success
Today’s capital markets are highly efficient, and very often both advances and declines are projecting future economic data. To us, this suggests that much of the returns investors experienced in 2013, especially the exceptionally strong rally in 4Q 2013, were anticipating the steadily improving economic and business environment we now have in 2014. Today, global financial conditions and credit markets are for the most part stable, liquidity is plentiful, employment trends are positive and global economic data continues to point toward steady, if not spectacular, growth. But even the preponderance of these positive factors may not be enough to propel markets measurably higher for the balance of 2014. Before getting into further detail on this subject, we do not want to give the impression that we have a bearish mentality. To be clear, we remain strategically optimistic.
The first conditional factor worth mentioning is the growing sense of complacency among many investors. Domestic equity markets have now gone 915 days without a 10% pullback, which is among the five longest periods of time for this to occur since World War II. Nothing attracts attention like success, and the higher equities have advanced, the more money has flowed into this asset class. Most institutions are closer to fully allocated to equities than at any other time over the past several years. Because of this, we now view markets as extended and sentiment to be overly optimistic. Whenever the collective consciousness of the market moves to an extreme, it becomes susceptible to negative reactions when data or news runs to the contrary. We’ve already seen a few examples of this in the first quarter as markets have sold off following economic announcements; not because any single piece of data was particularly negative, but simply because it wasn’t as good as expected. When markets are “priced for perfection” an attitude of “buy the rumor, sell the news” often arises. Investors should be prepared for an increased level of day-to-day volatility until these expectations have been more appropriately tempered.
Another short-term headwind is valuations in domestic equities. We don’t view domestic equity valuations as excessive, especially when compared to other investable asset classes, but the truth is domestic stocks are no longer ‘cheap’. Over the past few years, being undervalued offered markets a buffer during periods of economic uncertainty and helped to act as a floor for asset prices. But, recent gains have removed this safety net, and have called into question just how much more equities can rally near-term. It is important to note that the great majority of last year’s gain is attributable to multiple expansion instead of strong earnings growth. In 2013, S&P 500 earnings grew by just 6% year over year, yet the S&P 500 index returned over 30%, representing a jump in the forward price/earnings ratio from 13x to 17x. While a forward P/E of 17 is justifiable when placed in its proper context, investors should not expect to see similar multiple expansion in 2014. Without multiple expansion, consensus earnings growth in 2014 will not likely support significant price upside this year.
Differentiation and active management
We expect markets to enter into a period of extensive differentiation within and across asset classes. Since 2008, correlations have been high as markets have, for the most part, been either in “risk on” (everything goes up regardless of fundamentals) or “risk off” (everything declines regardless of fundamentals) mode. No doubt investors have benefitted from the recent period of “risk on”, but as this bull market matures, and as we move deeper through the business cycle, we’d expect these high correlations to decline and for markets to apply more scrutiny in differentiating between the winners and losers. This separation and offset will make it more difficult for the overall equity indexes to advance. However, as this takes place, we would expect our active managers, who build investment portfolios by purchasing the marketable assets of high quality, fundamentally sound businesses, to begin to distinguish themselves and provide true value add and relative outperformance (alpha generation) for our clients.
Again, the topics covered above are all conditional factors, and are used to help explain our short-term (3-6 months) perspective on the current market environment in order to help set reasonable expectations for our clients. When conditional factors move toward one extreme or another, they are resolved through either price, time or a combination of both. Underlying secular trends should eventually reassert themselves. With an emphasis on global asset allocation and broad diversification, we prefer to think strategically, and focus on long-term, dominant trends and investable themes rather than overreacting to any short-term, headline grabbing “noise”. From our vantage point, this remains the best approach for achieving long-term investment goals with appropriate risk/reward.
To reiterate, we remain strategically bullish on global equities and look to be equal weight relative to client specific policy. Interest rates are likely to rise incrementally and in-line with economic expectations. Because rising interest rates will put pressure on bond markets, we are increasing our use of diversified, hedged alternatives and reducing traditional fixed income holdings. We are constructive on 2014, but we suspect it will be a bumpier ride. As always, please contact us with any questions or comments.