Global economic acceleration will continue, but there are some issues in Asia. The Fed is expected to keep interest rates zero bound. U.S. stocks should continue to be attractive, particularly in the financial sector. Short-term volatility is expected in the first half of the year. The so-called “Great Rotation” out of bonds into stocks may be more muted than expected. These are the key takeaways from the presidents, chief investment officers, and other leaders within the investment divisions at Fidelity, from their December roundtable discussion on the year ahead.
Jacques Perold, president of Fidelity Management & Research Co., moderated the discussion. [Note: The following views represent those of one or more individuals, and should not be considered as the collective view of either Fidelity Investments or any particular investment division.]
Jacques Perold (Moderator): Let’s start with the global macroeconomic backdrop and its implications for the financials markets.
Chris Sheldon (Chief Investment Officer, Private Wealth Management): The global economy is beginning to gain a modest degree of momentum. In the U.S., uncertainty has diminished as the Federal Reserve (Fed) has focused on the distinction between tapering and tightening, which they do not anticipate for quite some time. Bond market response to the December meeting announcement that tapering is anticipated to start in January was subdued compared to the prior episode in June 2013, and equity markets responded favorably. Further, the recent U.S. fiscal budget compromise,1 while not resulting in significant fiscal progress, indicates a desire to end the political brinkmanship and move forward, which may also help to reduce uncertainty. I think we could see U.S. GDP growth accelerate towards 3% by the end of 2014, which could put some upward pressure on the 10-year Treasury yield, but not dramatically so because inflation is likely to remain subdued. Looking abroad, there are some signs of economic improvement in Europe, and security valuations on average are attractive in several asset classes. So, it is possible we could continue to see improvement in European financial markets.
Lisa Emsbo-Mattingly (Director, Asset Allocation Research): I largely agree with Chris’s assessment. I think acceleration in the global economy will likely continue. Some negative macro events, such as the Japanese tax hike and Fed’s tapering, could temporarily disrupt the equity markets in the first half of the year, and such events may benefit the fixed-income markets as investors flee to them for relative safety. But in the second half of 2014, I believe it’s quite possible that the equity market benefits from the return to a “Goldilocks” type of environment—not too hot, not too cold—featuring single-digit earnings growth and continued multiple expansion.
Perold: What markets are of the greatest concern?
Emsbo-Mattingly (Asset Allocation Research): I am concerned about Asia. In Japan, the economy has accelerated, credit conditions have improved, and corporate profitability is up. However, the drivers of this growth have primarily been fiscal stimulus and a weak yen policy. Another concern is that the increase in household spending we have seen is “pre-buying” before a consumption tax hike in April 2014. The government has yet to implement any significant structural reform, debt levels remain high, and the demographics aren’t ideal. In 1995, Japan began a weak yen policy and in 1997, the weak yen coupled with the last consumption tax hike led to negative ramifications for the Korean and other Asian economies. Today, I think this weak yen policy could impact China, Taiwan, and other emerging markets.
Perold: What might we expect from the Fed in terms of policies in 2014?
Bob Litterst (Chief Investment Officer, Money Markets): During the past few months, the Fed has been much more aggressive with its forward policy guidance, and I expect that will continue in the coming year. Since September, the Fed’s forward guidance has been very effective at anchoring expectations of implied, future short-term policy rates near the zero-bound level, while the 10-year Treasury yield has oscillated between 2.5% and 3.0%, keeping the curve fairly steep. The Fed previously had been concerned about the sharp increase in implied, short-term rates that occurred in late summer, which I believe suggested to central bankers that the market had a different view about the Fed’s tightening process than the one they wanted to convey. Since then, the Fed has articulated much more straightforward and aggressive language to set the expectation that “tapering” their asset purchases is not, in their view, seen as a “tightening” of monetary policy. With an economy growing at 2% and a labor market that has stabilized at a reasonable pace of job growth, I believe the Fed sees less need to maintain its current unconventional stimulus monetary policies, and we saw evidence of that with the recent announcement that the central bank will begin tapering its asset purchases in January 2014.2
I also think it’s worth recognizing that the new reverse repurchase agreement facility the Fed put into place in September so far has worked quite well in providing a floor for short-term rates. This facility was intended to enable the Fed to better control short-term rates and reduce short-term rate volatility while maintaining a very large balance sheet and excess reserves in the system. During the past few months, as the Fed has increased the rate on this overnight repo facility, market rates have responded accordingly. Although this new facility is currently in a testing phase (scheduled to end in January) and is still an experiment, our expectation is for this program to become permanent at some point in 2014.
Perold: Why do you think the Fed began tapering at this point?
Litterst (Money Markets): I think it was a combination of better private data on the economy and a more settled fiscal situation that is expected to exert less drag in 2014. These developments tipped the scales in favor of taking an initial deliberate step in reducing monetary accommodation.
Perold: What is the outlook for U.S. equities?
Brian Hogan (President, Equities): I am optimistic about the outlook for U.S. equities in 2014, for a couple of reasons. First, the average dividend yield on the S&P 500 Index is about 2%, and the recent rate of share buybacks for S&P 500 companies has been 1% to 2%,3 which provides a boost to earnings-per-share growth. So, equity investors are likely going to start 2014 with a tailwind of about three percentage points and there could be further support for stocks if companies produce earnings growth in a range of 6% to 8%. So, I think there is a realistic probability of achieving a high single-digit return in stocks. I also think there is a high probability that investors could see multiple expansion in stocks, largely because many alternative investment options have less compelling prospects. The equity market has come a long way in 2013, but valuations remain reasonable at 17.6x trailing earnings because earnings growth has outpaced stock price appreciation during the current bull market.4
Tom Hense (Group Chief Investment Officer, High Yield and Equities): As long as the average yield on stocks remains higher than those on shorter-term bonds, I think there could be further multiple expansion in equities. From a relative return perspective, equities still look more attractive than bonds on a total return basis.
Sheldon (Private Wealth Management): To me, the challenge right now for the U.S. equity market is that given the liquidity environment and the gains in 2013, it feels like we may have pulled forward some of the gains from 2014. For equities to rise significantly from here, I think we need to see greater confidence among both businesses and consumers. We do not see signs of excessive exposure to equities to indicate there is a “Great Rotation” under way, nor is it evident in hedge fund exposures that we monitor. Perhaps we might characterize the current flows of capital to equities as the beginning of a “Good Rotation,” with many investors maintaining cautious positioning in equities.
It’s important to keep in mind that in recent weeks there has been a disconnection between analysts’ (higher) earnings forecasts and a significant increase in negative (quarterly corporate) earnings warnings, or guidance pre-announcements, by companies.5 As a result, I wouldn’t be surprised to see some early 2014 equity market volatility as investors digest this dichotomy between analysts’ expectations and corporate guidance. I don’t think the degree of appreciation we saw this year is likely to continue in 2014. However, single-digit stock market appreciation in line with earnings growth and modest multiple expansion does not seem unreasonable.
Perold: What categories look attractive within the U.S. equity market?
Joe DeSantis (Chief Investment Officer, Equities): Generally speaking, price-to-earnings multiples in the financials sector are lower relative to other equity sectors because investors continue to doubt the eventual earnings power of financial stocks in the post-financial crisis period. Since late 2009, financials haven’t participated as significantly in the rally as several other sectors in the broader market. If financials sustain some earnings momentum, the stocks could perform well, particularly large banks, insurers, and capital markets and asset managers.
Perold: What about regulation and impending litigation for financial companies?
Emsbo-Mattingly (Asset Allocation Research): Regulation is one thing, but uncertainty is another. Uncertainty in any environment is a real negative dynamic for any market, economy, or sector. The final version of the Volcker Rule6 adopted by U.S. regulators this month provides clarity to large banks and other institutions. Before adoption of the rule, the banks weren’t entirely sure what game they were playing. Now, they know the rules of the game. Is this additional regulation good for the banks’ growth prospects? No, it isn’t, in my opinion. But I think that clarity is a more positive dynamic than the uncertainty that previously existed. In addition, whenever you have asset prices appreciating and a steep (U.S. Treasury bond) yield curve, it has been a good backdrop for financials.
Litterst (Money Markets): That’s a great point about unwinding uncertainty–it has definitely been a headwind for financials. I also worry about litigation risks and additional regulation that has been targeted at banks but has not yet been finalized by regulators. From a credit perspective, much of this regulation is a good thing because it makes banks more liquid and better capitalized. But from an equity perspective, this regulation may make it even more difficult for some banks to maintain the same level of business activity, profitability, and stock returns as they have experienced in the past. For example, proposed Fed regulation on leverage ratios could impact banks’ desire to be active in low-risk instruments, including Treasuries and agency securities. Additionally, there are Basel III7 regulations on liquidity, capital, and leverage that have been changing periodically over time and still have to be implemented.
Hogan (Equities): My guess is the banks, particularly investment banks, will adapt to the altered regulatory environment as they historically have done, and may eventually be revalued higher by investors.
Perold: What companies might benefit from new financial sector regulations?
Angelo Manioudakis (Chief Investment Officer, Global Asset Allocation): We’ve already seen alternative investment companies begin to pick up business that had previously gone to banks. A fair amount of the intellectual capital in certain business segments has already migrated from banks to these alternative firms, and I suspect this trend may continue as these alternative companies are financial engineers by nature.
Perold: Any other areas of potential opportunity?
Pam Holding (Head of Global Portfolio Management, Pyramis Global Advisors): I believe we are moving into an environment where we could see global synchronized growth. The U.S. continues to improve at a slow and steady pace, Europe is moving from weak to stable to even slightly positive in certain areas, and Japan should continue to forge ahead with structural changes that may support growth. This type of environment favors risk assets and in particular, areas such as the commodities/materials sector and emerging markets equities could benefit. Both areas have suffered for the past several years, and though you may not see improvement in the underlying commodity levels, materials stocks tend to move well ahead of the underlying commodity prices. In addition, these areas could benefit to a certain extent from mean reversion.8
Perold: What about the prospects for European equities?
Hogan (Equities): It’s possible the equity markets in Europe could be revalued to higher levels, even if there isn’t a lot of economic or (corporate) earnings growth, and that’s largely because of the positive outlook for equities elsewhere in the world. In the U.S., for example, there has been solid corporate earnings growth for the past four years, but stocks haven’t outpaced earnings growth during that period,9 and the equity market didn’t have an outsized year of performance until this year. In Japan, markets are being revalued to higher levels.
Tim Cohen (Chief Investment Officer, Equities): I agree—there is optionality in the European equity markets that doesn’t exist elsewhere in the world. It’s not uncommon for investors to underestimate a recovery after a recession or bear market. Corporate earnings overall in Europe are still well below the levels seen prior to the global financial crisis and recession beginning in 2008.
Perold: What's the outlook for the high-yield bond markets?
Hense (Equities & High Yield): Overall, the backdrop for the asset class remains supportive. The credit markets remain wide open, and credit default risk remains fairly low by historical standards. Demand for high yield, leveraged loans, and convertible securities from income-seeking investors remains strong. But we haven’t seen any of the major corporate buyout activity that typically occurs during a peak in the high-yield market. As long as economic growth continues at the current pace or improves, I expect coupon-like returns in the range of 4% to 5% going forward.
Perold: Bob, what’s the outlook on bonds from the fixed-income division?
Bob Brown (President, Bonds): Generally speaking, our fixed-income managers are positioned in riskier securities relative to their benchmarks, but to a far lesser extent than many of our competitors. With respect to duration and credit, I think we are appropriately positioned overall. In my view, the great fear of a potential spike in rates is just that—more fear than reality. My outlook for the 10-year Treasury bond yield is limited over the short term, and I believe the so-called “Great Rotation” out of fixed income and into equities will be more muted than the broader market expects. To that end, we’ve recently seen increased demand for liability-driven investing strategies from institutional clients, indicating strong demand for fixed income.
Perold: What's the overall perspective from the asset allocation division?
Bruce Herring (Group Chief Investment Officer, Global Asset Allocation): From a macro perspective, I think the Fed has done a decent job of addressing the problems in the financial system. With respect to the domestic economy, the Fed has faced a stubborn opponent in terms of sparking economic growth—especially on the lower end of the economic spectrum. One of the (economic) indicators I like to watch is the number of Americans participating in the U.S. government’s food stamp program (i.e., the Supplemental Nutrition Assistance Program). When the number of participants in this program spikes, it indicates stress in the economy. However, for the first time in years, the level of food stamp recipients has flattened and declined.10
We know that in the upper end of the economic spectrum, consumers are in good financial health, as evidenced by strength in the housing markets, automobile sales, and the financial markets. Going forward, I think there is a realistic chance that we could see spending and growth accelerate in the lower end of the economy. Meanwhile, the “Goldilocks” backdrop of improving economic growth, accelerating earnings growth, and accommodative monetary policy should continue to provide positive support for riskier assets.
3. Source: FactSet, as of November 30, 2013.
4. As of Sep. 30, 2013, the P/E ratio of the S&P 500 Index using trailing earnings was 17.6, compared with 18.2 at the end of 2008 and an average of 19.5 since 1995. The below-average P/E of the equity market today (17.6 on trailing earnings versus the average of 19.5) suggests that investors are anticipating only modest earnings growth in 2014 and beyond, which may bode well for stocks if companies surprise on the upside. Source: Standard & Poor’s.
6. Volcker Rule: Named after former Federal Reserve Chairman Paul Volcker, aims to minimize conflicts of interest between banks and their clients by separating various types of businesses that financial institutions typically engage in. The rule was introduced after the 2008 global financial crisis to minimize risk in the financial system.