The Slow and Deliberate Path to NormalizationJanuary 2014
2013 was a fascinating year in many respects, in some ways pleasantly surprising, in others misleading or, perhaps, simply baffling. We will attempt to shed some light on certain developments over the past year and consider them in the context of the breadth of the period following the Great Recession.
One of the more notable market features of the past year was the dispersion of returns across the broader capital markets. In the context of highly divergent global equity, fixed income, and cash returns, U.S. equities were far and away the best performing category. Outside of the returns for developed equity markets, many asset classes failed to generate positive returns for the year, among them fixed income and most commodities, with oil being a notable exception. Even worse was the performance of gold, which experienced a dramatic decline of 28% during 2013.
Financial Markets Review—2013
When viewed in the context of the broader global equity universe, the performance of U.S. equities was not only impressive in the absolute but also on a relative basis. The U.S market produced substantial excess returns relative to broad international equity markets, with the performance differential relative to emerging markets even more dramatic. Emerging market equities not only performed poorly compared to developed markets but, in fact, also experienced disappointing returns in the absolute, declining 2.4% for the year (Chart #1).
Fixed income markets in 2013 reached what we view as an inflection point with the trend of declining interest rates reversing during the year. The prior year’s uniformly positive absolute returns across all domestic fixed income asset classes were replaced by 2013’s largely negative ones, the first negative returns since 1999. While corporate credit remained in favor, investors shifted their preference along the yield curve, moving from long end to short end positioning. Long dated assets, in a turnaround from 2012, weakened dramatically as global yields sharply rose in the months following introduction of Federal Reserve taper fears in May. On a global basis, the U.S. fixed income markets experienced positive relative returns compared to International and Emerging Markets bonds, though all three were negative in the absolute.
As noted, corporate credit once again was the best performing fixed income sector. On a relative basis, investment grade corporate credit outperformed Treasuries, producing flat to slightly negative returns, while High Yield corporate debt was the best overall sector performer with an absolute return of almost 7%. The broader tax-exempt municipal market, after experiencing dramatic outperformance in 2012, exhibited negative performance for the year and underperformed relative to the taxable market. The taper fears manifested themselves in accelerated outflows from municipal mutual funds that continued unabated through year end. Compounding the outflow-driven pressure on the long end of the municipal yield curve were a rolling series of credit concerns over Puerto Rico and Detroit, which placed additional pressure on the municipal market.
The Road to Recovery in the U.S.
U.S. equity markets rose 32.4% (including dividends) in 2013. Returns were broadly based across sectors and the market largely avoided prolonged corrections, generating positive returns in every month except May and August.
Given the price movement over the last two years, investors are concerned that the market has come too far too fast, a natural conclusion when viewing 2013’s robust equity returns through a lens of modest global growth and the historical return experience. The year’s performance was the strongest since 1997.
While the S&P 500 has been gaining since the market lows of March 2009, it has exhibited a robust 45% rally since the middle of last year. Given such an impressive return in a setting of modest economic and corporate revenue growth, many investors have become concerned about growing risks. Taking a step back and looking at equity returns in the context of the post credit crisis period (2009—2013) we hope will provide some perspective. Certainly, this period of time can be fairly characterized as unprecedented in recent history, however there are two important features to the rally that we believe require consideration. First, the private sector of the economy appears to be slowly recovering and, second, the Federal Reserve altered the cost and return of capital for both borrowers and savers. Fiscal and, in particular, monetary policy was (and remains) unprecedented during this period and continues to influence the economy and markets even with the gradual diminution of those extraordinary policies. As a consequence of a loose fiscal policy bias transitioning to a tightening one, the rate of change for both federal and state spending varied significantly from year to year. The public versus private dynamic was particularly noteworthy in 2013. In fact, the shrinking federal government sector became a drag on overall economic growth, subtracting an estimated -1% from GDP. In contrast, the private side of the economy, which accounts for almost 80% of economic activity, continued to expand consistently , and in nominal terms is considerably higher than the period before the onset of the credit crisis (Chart #2).
Corporate Profits Exceeded Pre-Crisis Levels
Ultimately, we believe domestic equity markets are a proxy for the overall health and profitability of corporate America. In 2013, the S&P 500 surpassed the previous pre-crisis market highs of 2007, reflecting the solid financial position and balance sheet strength of most companies. For the better part of the past five years, domestic equity market levels marched higher since hitting lows in March of 2009 (Chart #3). During this time, corporate revenues, earnings and valuation levels all returned to or exceeded pre-crisis levels. The first phase was a bounce in corporate revenues, followed by increasing earnings and, finally, dramatic improvements in valuations.
Today, valuations are, for the most part, in the realm of fair value as measured by the trailing earnings multiples of the S&P 500. Investors have become more comfortable with how much they are willing to pay for an expected unit of earnings. Investors appear to have shifted their focus from risk aversion to a more balanced view of risk and return. In hindsight, the normalization process took 5 years and only saw absolute market and valuation levels surpass their pre-crisis highs in 2013. Essentially, market valuations for the better part of the last five years have traded at a discount to their longer term averages, reflecting investors’ caution regarding the economic and political landscape. This embedded risk premium moderated during 2012 and 2013. Thus, we believe the robust return experienced over the past two years should be viewed as a recovery or recapture phase and more reflective of today’s corporate fundamentals, both from a profitability and a valuation perspective (Chart #3 and #4).
Recalibration of Risk
At this point, some five years after the recession, investors are more comfortable assessing and pricing risk. It is not surprising to us to see a number of key markets signaling a similar central theme. We believe the market moves in stocks, interest rates and gold since the fall of 2012 reflect this dynamic.
While there are always causes for concern, when viewing today’s conditions relative to the previous five years it is no coincidence that risk premiums have moderated from elevated levels. During the peak of the crisis Treasuries and gold, long considered safe havens during times of economic and political turbulence, were in high demand. The 10 year Treasury note, which was hovering around 4% in October of 2008, declined for several years before bottoming near 1.50% in 2012 (Chart #5). Gold rose 24%, 30%, and 10% in 2009, 2010 and 2011, respectively (Chart #6).
Given an environment of great uncertainty and elevated systemic risk, it was not surprising to see the price of Treasuries and gold jump immediately following the market events of 2008. Further, given the magnitude of global central bank intervention, many investors were concerned about a declining U.S. dollar and the potential for rising inflation. This fear proved unfounded, as 2012 and 2013 saw falling rather than rising inflation as non-traditional monetary policy failed to fully filter through to the real economy.
Perhaps unsurprising given the recalibration of investor sentiment in favor of riskier assets, gold dramatically sold off in 2013. The 2011 peak in gold matched a dramatic spike in volatility, a proxy for systemic fears, centered on U.S. political risk stemming from the debt ceiling crisis and attendant downgrade of the United States’ long term credit rating. 2012 saw lower volatility as political crisis fatigue set in, along with weakening inflation. This perception of reduced risk paved the way for higher equity valuations (as measured by P/E multiple expansion) in 2012 and 2013. Reduced systemic risk and an improving perception of opportunity within equity markets heightened pressure on gold prices. 2013 also saw better economic data, muted inflationary pressures, and an increased market indifference to government gridlock, along with no notable systemic shocks. These factors provided the fuel for risk assets to post stellar returns, while gold suffered a return of -28%, or almost 60% relative underperformance compared to the equity market.
After much speculation the Federal Reserve adopted a change to its asset purchase program referred to as “Quantitative Easing”, in December reducing the monthly rate of purchases of U.S. Treasuries and mortgage-backed securities from $85 billion to $75 billion. We believe that over the next few years we will continue on a steady path towards normalization in economic growth, interest rates and ultimately monetary policy. Our expectation is that we will not experience a dramatic rise in the term structure of rates in this relatively short time period. Our investment thesis is that this expected steady rise in rates will unfold over several years and will impact different parts of the yield curve according to anticipated and actual shifts in policy by the Federal Reserve. Specifically, we want to differentiate policy action as it relates to non-traditional monetary policy (QE) and traditional monetary policy (Fed Funds rate). The point being “tapering” isn’t the same as “tightening” and policy action is sequential not simultaneous. The adjustment in policy and interest rates will occur in phases and over an extended time frame. As of the end of 2013, we have seen a normalization occur in equity market valuations. However, the process of returning to some level of normalcy in interest rates, economic growth, monetary policy and valuations across the broader capital markets will occur over a number of years.
In a traditional asset allocation model of stocks, bonds and cash we view the latter two asset classes as being several years away from returning to "normal". The yield environment has been considerably below historical levels for several years. For instance, in the decade preceding the crisis (1997 to 2007) the 10-year treasury note averaged approximately 4.8% and the 2-year note averaged 4.0%. Even with the rise in rates in 2013, both the 10-year note and 2-year note still stand considerably below their historical average (Chart #7). The prospects for bonds as interest rates gradually normalize will be a return profile considerably below historical norms. In a low return environment it would not be particularly surprising to see risk assets which typically exhibit reasonable risk and return characteristics trade at a modest valuation premium during this normalization process. We continue to believe cash will have no associated return expectations until 2015 and perhaps not until 2016. All told, we feel confident that investors will have ultimately experienced at least six years of near zero short-term interest rates and maybe a decade of an exceptionally low Fed Funds rate before monetary policy fully normalizes. In this environment, stocks may evolve from originally trading at a risk premium to a price premium.
2014 Market Outlook
Our view is that we continue to see the U.S. economy recover at a moderate pace while the rest of the developed world shows moderate improvement over last year’s levels. Over the next year, the U.S. should benefit from a declining drag from the government sector, improving growth outside the U.S., accommodative global monetary policy, low inflation and, hopefully, private capital investment in labor, equipment and infrastructure. As this backdrop unfolds, we would expect to see a continuation of recent trends as they pertain to stocks, bonds and cash.
We anticipate a reasonable return environment for risk assets relative to the robust returns generated during the past two years, albeit with increasing market volatility. We continue to tilt portfolios toward an equity bias as investors are still compensated for the assumption of risk in relative terms. It is our expectation that global equity markets will generate excess returns over bonds and cash in 2014.
Looking back, it has been an extraordinarily challenging period for everyone, from investors to savers and to policy makers. We have included a table which highlights some of the unusual events that have occurred during the road to recovery (Chart #8).
Despite persistent headline news regarding unsustainable budget deficits, a dysfunctional political class, and the lack of long term sound fiscal policy, there are improving trends in critical areas. Growth, fiscal discipline, housing, banking and the balance sheets of individuals and corporations all show notable, though modest, improvements. We believe these improvements are reflective of a slow but now steady recovery, still many years from normalization. In the interim, we believe the following short term trends are favorable and will be supportive of equity returns:
Reflecting on events since the onset of the financial crisis, it has been demanding and even unsettling at times. We would like to thank you for allowing us to serve you through this extraordinary period in history.
This communication is intended solely to provide general information. The information and opinions stated are as of December 31 2013, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Executive Vice President and
Director of Fixed Income Strategies
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