- The backdrop to the financial markets is filled with risks, and among the most concerning are uncertainty tied to fiscal austerity implementation, questionable prospects for U.S. and global growth, and decelerating earnings growth.
- Our investment leaders are optimistic that some form of resolution to the U.S. fiscal cliff issues will provide the clarity needed for companies to engage in business spending and spark broader investor demand for U.S. equities.
- Within the equity markets, some themes that look promising in 2013 include the housing market recovery, companies with the ability to create shareholder value via higher dividends or share buybacks, mortgage servicing companies, and undervalued stocks that haven’t fully participated in the 2012 equity market rally.
- Issuance and demand for high yield bonds remains robust, and there are few imminent signs of a slowdown in 2013.
- Fixed-income and money market investors should: be wary of the risk involved when the Fed decides to unwind the assets on its balance sheet; keep an eye on economic growth; and be mindful of the diversification benefits of owning bonds in a diversified portfolio over time.
The presidents, chief investment officers, and other leaders within the investment divisions at Fidelity Investments gather regularly to discuss market conditions, significant risk factors, and other dynamics driving the performance of the financial markets. The following represents the most recent Investment Roundtable discussion in December 2012, which focused on the challenges facing investors in today’s market environment and the outlook for various asset classes in 2013. Jacques Perold, president of Fidelity Management & Research Co., moderated the discussion.
There are a tremendous number of issues around the world that have been influencing the performance of various asset classes. Let’s start with the equity division. Bruce, can you provide some perspective on how things played out this year, and what investors might expect in 2013?
Bruce Herring (Equities): I think it could be a more difficult environment for equities in 2013. At this point last year, the U.S. economic backdrop was fairly stable. Corporate profitability was strong. And although the equity market was fighting weak sentiment in the marketplace and low valuation levels to some extent, corporate fundamentals—such as sales and earnings growth—kept powering ahead. It’s very different now. The rate of sales and earnings growth has slowed. Since Labor Day, investors and corporate leaders have focused more on the November election, uncertainty tied to the fiscal cliff,1 and issues such as tax rates, sequestration, and health care requirements, among others. The equity market is really looking for clarity on these fiscal issues so that businesses can move forward. If our legislators can make modest progress on some of them, I think it will be very beneficial for the economy and for equities in the coming year.
So you don’t feel a grand deal on all the fiscal issues is necessary for the equity market to move forward?
Herring (Equities): I don’t. I don’t think the deal itself matters as much as the clarity needed around these issues. The equity market just needs a path. If it receives that, then more corporations can begin to work toward solutions, and to use the record levels of cash on their balance sheets to grow their businesses. There is enormous wealth creation potential and pent-up spending power in corporate America right now. What we need to do is unleash it.
Brian, can you provide some insight on U.S. corporate profits, and how profitability could be influenced by fiscal austerity in 2013?
The following are regular participants in Fidelity Investments’ Investment Roundtable session:
President, Fidelity Asset Management and Corporate Services
Chief Investment Officer, Pyramis Global Advisors
Chief Investment Officer, Equities
Chief Investment Officer, Global Asset Allocation
Group Chief Investment Officer, Equities and High Yield
Group Chief Investment Officer, Equities
Chief Investment Officer, Money Markets
President, Fixed Income and Vice Chairman, Pyramis Global Advisors
President, Fidelity Management & Research Co.
Executive Vice President, Investment Business Development
President, Money Markets
Chief Investment Officer, Bonds
Chief Investment Officer, Global Asset Allocation
President, Global Asset Allocation and Vice Chairman, Pyramis Global Advisors
Brian Hogan (Equities): On average, profits are higher today than a year ago, but the pace of earnings growth has decelerated. Our analysts have been cutting earnings forecasts (on average) for several straight months. If you look back on the past couple of years, there’s been a transition under way. In 2011, the U.S. equity market (S&P 500® Index) had strong earnings growth but the market perspectives multiple (i.e., price-to-earnings ratio) contracted because investors remained apprehensive about owning stocks due to unresolved macro/fiscal issues. This past year, the equity market has had a combination of modest earnings growth and some multiple expansion. For 2013, however, the irony is that I think there could be lower earnings growth, but greater multiple expansion, particularly if there is some progress on the fiscal issues to provide clarity and prompt more investors to be comfortable owning equities.
Tom Hense (Equities and High Yield): It’s also worth recognizing that if corporate earnings growth is more modest as we expect, companies may pay out more in the form of dividends or share buybacks, which would be supportive of equity prices.
Herring (Equities): Fiscal austerity will have some impact on earnings growth, no question. But it is possible that the market may already be pricing that in to some extent. Greater visibility on tax policy and other issues will allow companies to plan and react accordingly to a “new normal.” At least companies will know what the playing field looks like, and so will investors.
What is the value proposition going forward for both U.S. and foreign equities?
Herring (Equities): Generally speaking, international equities are cheaper than U.S. equities from a valuation perspective (price-to-earnings ratio), primarily because earnings abroad have been more cyclically depressed amid the recession in Europe and slower growth in China. In addition, investors often can obtain a higher dividend yield from foreign equities.
Joe DeSantis (Equities): As in the U.S., our earnings estimates for foreign developed-country equities have been cut significantly throughout 2012, and estimates for 2013 have come down as well. From a relative standpoint, we see fewer positive catalysts to jump start the European economy compared to the U.S. economy over the near term. Both markets are facing a period of austerity, which serves as a headwind to growth across the board. So I think the outlook for both markets comes down to domestic demand. In the U.S., there is modest job growth and a moderate housing recovery under way, which are two positive drivers that can lead to a gradual improvement in consumer confidence, particularly among small businesses that are so critical to economic growth. Right now, neither of those drivers is taking place in Europe or Japan.
Hense (Equities and High Yield): It’s also worth noting that many U.S. companies have advantages today relative to their global competitors. For example, some domestic companies, such as refiners and chemical producers, are experiencing higher profitability as a result of lower input costs for U.S.-produced crude oil and natural gas relative to what is paid by foreign companies for these commodities.
Despite significant macro challenges, equity returns have been quite good in 2012.
Herring (Equities): It has been a very “risk on” market since July, when (European Central Bank President) Mario Draghi stated that the central bank would do “whatever it takes” to preserve the eurozone’s common currency. Since then, riskier assets have rallied around the world, and foreign equities generally have outperformed U.S. equities. There has been an increased appetite for risk, and the equity markets have been remarkably resilient despite the fiscal cliff and other issues.
Bill Ebsworth (Global Asset Allocation): Equities’ solid performance has been somewhat surprising to many. Individual investors who are saving for their retirement or other goals are battling a persistent overhang of doom and pessimism fueled by alarmist headlines and predictions of the “death of stocks and bonds.” There are absolutely some key risks that we’re all keeping a close eye on, but data continue to reveal slow but positive growth and other reasons to be hopeful for the future. Some have already been mentioned, including a durable recovery in housing and rising consumer confidence. Given all the risks out there, I could be wrong, but I personally believe slowly improving consumer confidence will pull investor sentiment along, rather than the other way around.
Hogan (Equities): I think you are spot on, Bill. The equity markets often work in ironies. There is absolutely an economic recovery going on in the U.S., and while it may be slow and gradual, it is supportive of equity prices. Whatever form of austerity arises in the U.S. will have some detrimental influence on earnings, but I am optimistic that the removal of the lingering uncertainty will cause equity multiples to expand. When investors refer to equities as “riskier assets” today, it is very likely that they may be overestimating the risk in equities and underestimating the risk in other assets. I think there is a strong possibility that when you look back 10 years from now, many investors may realize there was considerably higher-than-expected risk in owning U.S. Treasuries at current price levels.
Bob Brown (Bonds): From my perspective, the strong performance of the equity markets continues to be fueled by an infusion of liquidity by central banks around the world, which has kept interest rates on fixed-income securities low and forced many investors to seek higher returns elsewhere. I don’t have any doubt that central banks will continue to provide support as needed in 2013.
What are some specific areas of risk and opportunity that investors should be mindful of?
Young Chin (Pyramis Global Advisors): What we have been talking to clients about in the past few weeks has been the magnitude of the rotation to bonds that has taken place this past year, and the appreciation in bond prices. Is there further value at current yield levels, particularly if an investor is overexposed to this asset class? Meanwhile, other high-quality, high dividend-paying equity assets that are part of low-volatility investing strategies, such as consumer staples, telecommunication services, and insurance, also have appreciated significantly. From a tactical standpoint, we are trying to help our clients determine where the next rotation in the equity market will take place. Some value stocks, including financials, which did well this past year but have not participated fully in the post-financial-crisis equity market rally, could continue to lead in 2013. I think it’s a mistake for investors to wait to enter the equity market until there is clarity on the fiscal cliff. The time to get into the market could be now—not necessarily after the issues are resolved and while the market may be in the process of moving higher. There just aren’t a lot of people pounding the table for equities right now.
Ebsworth (Global Asset Allocation): Investors may also be underestimating the power of the housing market recovery and its significance both for the economy as well as a number of stock market sectors. During the global financial crisis, housing’s contribution to U.S. gross domestic product (GDP) dropped to about half its historical average, and way below the peak it reached in 2005.2 So any recovery back to its long-term average has a strong direct effect on our economy. In addition, economists estimate that for every dollar spent on a home, another $1.27 is spent on things such as improvements, furnishings, appliances and more. This is a positive development for the economy as well as industries such as home improvement stores, furniture makers, appliance manufacturers, and banks that lend the money for home purchases and improvements.
Christine Thompson (Bonds): One reason why the housing recovery has been slow is the tighter credit conditions that have been applied by banks and other lenders. The gate to financing still remains historically tight, which points to ongoing moderate growth in the housing market. Another area of opportunity is mortgage lenders and loan servicing companies, which have been experiencing higher profits given the historically high spread between home financing costs and mortgage rates.
The equity market had been highly correlated a year ago, which posed a challenge for equity investors. Has this been a frustration for active portfolio managers more recently?
Herring (Equities): Year to date through November, the best-performing equity sector—consumer discretionary—was up 23%, and the worst—utilities—was up just 1%. Meanwhile, correlations (using trailing six months of monthly returns) among equities have trended much lower.3 Those two points suggest that there has been plenty of dispersion within the equity markets in 2012, providing greater opportunity for active managers to add value. Active investors tend to benefit in trending markets, particularly upward trending ones, but that type of market hasn’t occurred in several years. More recently, there have been constant equity-market rotation and “risk on/risk-off” rotations over the short-term. Our portfolio managers have been focusing more on identifying the best-performing companies over a longer-term horizon. The historically low portfolio turnover rates among many of our largest portfolios are reflective of the longer-term approach we are trying to manage to.
Tom, could you provide some context on the high yield market?
Hense (Equities and High Yield): The high yield market has rarely been hotter than it is right now. High yield and structured credit issuance is robust and investor demand remains strong, particularly from institutions such as insurance companies, endowments, and hedge funds. There hasn’t been a significant increase in credit delinquencies across the board. Corporations have had access to cheaper financing and better terms, which has allowed many to refinance existing debt issuance and issue additional debt. In some cases, valuations are a bit elevated, but I don’t see anything on the near-term horizon that could alter these dynamics. This bodes well for corporate America, the U.S. economy, and investors: the high yield market is the lifeblood of corporate America, and when it’s flowing, everything else tends to follow suit.
What about the emerging-market debt universe?
Hense (Equities and High Yield): I would characterize it as being very similar to the U.S. high yield market, although there is an investment-grade component to it. Business fundamentals and valuations have continued to improve. Countries and companies by and large have been very rational in terms of extending credit.
Bob, what are likely to be some of the challenges facing investors and issuers of money market securities in 2013?
Bob Litterst (Money Market Securities): In the current low rate environment, companies that issue money market securities to meet their short-term funding needs are able to borrow at very low costs. I would anticipate that access to such low-cost funding would be supportive of the fundamental outlook for companies for many years to come. Meanwhile, the Federal Reserve’s (Fed) recent change in communication from a date-based form of guidance to threshold-based guidance was noteworthy. Specifically, the Fed is now providing benchmark targets for unemployment (6.5%) and core inflation (2.5%) as indicators of a potential future shift in current policy. This suggests to me that the central bank will continue to do everything it can to support the labor markets and economic activity. Finally, I don’t think many investors are focused on the implications and challenges facing the Fed in trying to unwind the significant amount of assets on its balance sheet. The Fed has never unwound an asset base of this size before, and there are fewer counterparties available for the Fed to deal with in the post-financial-crisis world. Depending on the Fed’s exit strategy, the impact on the financial markets could be extreme.
Thompson (Bonds): I agree with Bob’s view. At this point, we don’t know the exit path the Fed will take. Will it be gradual, and if so, how gradual? Does it exit over the course of years, or by a combination of selling and maturing portfolio holdings? As investors, we have never been through this before. But the fear is that the Fed’s exit strategy turns what is now a stabilizing factor for the markets into a destabilizing factor. Personally, I think the Fed’s exit will be gradual, and it won’t take place until the economy is on a clear path of sustainable economic growth.
Christine, what should investment-grade bond investors be monitoring as we move ahead in the coming year?
Thompson (Bonds): What most of our analysts are watching now is GDP growth. The bond market remains highly linked to the economy, and is very concerned about how our leaders in Washington implement austerity, which has hindered economic growth in other countries. At the same time, an acceleration of growth could weaken the outlook for bonds. Many of our clients have been wondering what we would do to manage their fixed-income assets through a period of rising inflation and rising interest rates. I expect our portfolio managers to continue to work within the parameters of our investment mandates. In those strategies that have flexibility to own assets that have less interest rate risk, we always consider valuation factors that may lead to increased exposure to “plus” sectors that offer higher yields, such as higher-yielding bonds and emerging-market debt.
Looking across the various bond sectors, yields remain very low and spreads have narrowed, but there still remain pockets of opportunities to add value through spread tightening. While it may be hard to argue that bonds provide better total return potential going forward than other asset classes given low absolute yield levels, investors should remain mindful of the diversification qualities that bonds can provide to a portfolio over time, such as relative price stability in weak economic environments.
With regard to portfolio construction, Bill, could you provide an overview of the investment views in the managed accounts division?
Ebsworth (Global Asset Allocation):We continue to believe in remaining fully invested, diversified, and focused on the long term. We’ve also positioned our portfolios to modestly reduce their overall risk levels. This positioning reflects our belief that global economic growth may slow.
During the past year, we’ve slightly lowered our exposure to U.S., developed-country international, and emerging-market stocks. We’ve been underweight U.S. Treasuries but remain overweight in credit and non-U.S. bonds, which we’ve trimmed recently. We’ve also locked in gains in high-yield bonds, and managed the risk levels in gold miners and commodities.
In addition, we’ve added more conservative investments, including core income strategies, short-term investments, and money markets. We’re also emphasizing investment managers and disciplines that we believe will add value in the later phases of the economic cycle.