Dirk Hofschire’s key takeaways
- A favorable start for the U.S. economy in 2014, but a chance for a bumpy ride for stocks.
- A somewhat cautious outlook over the next year or two for China.
- Japan’s economic momentum faces potential speed bumps.
The outlook for 2014 looks positive, although 2013’s big stock gains may not be repeated. That’s a key takeaway from Dirk Hofschire, senior vice president of Asset Allocation Research, in his December market commentary. He explains why and also discusses what it means for the markets and investors in his monthly market update, with Lars Schuster, institutional portfolio manager for Strategic Advisers, Inc., a Fidelity Investments company.
Schuster: What are you seeing in the global markets and economy?
Hofschire: The U.S. stock market has had big gains, as have many developed equity markets around the world, including Europe, Japan, and other places. We are seeing less solid returns from bonds, where interest rates have gone up. Also, commodities in developing economies have been tied to other places in global growth. But overall, if you think of it as a diversified portfolio, the results are not bad. However, we definitely had more dispersion among different asset categories than we have had in recent years.
Schuster: China held historic meetings resulting in reforms for the next several years. Can you explain what that means?
Hofschire: China conducted some very important meetings on economic policies that they are going to be pursuing over the next several years. The meetings confirmed the direction that Chinese policymakers have taken over the past year, which was the first year of the new administration. They want more private-sector orientation in the economy. They want more market-driven mechanisms, especially in the financial sector, to help allocate capital. So, as a whole, I think the leadership appears more disposed toward economic reform than at any point in the past couple of decades. However, I think the implementation is going to be difficult and we have to keep in mind that these are multiyear goals. Things are not going to change overnight. In the short term, China's economy appears stable, but one of the other reasons it’s been stable recently is that they've allowed even more credit expansion. Property prices are going back up because of more government-driven infrastructure projects. These drivers are based on the old model of growth, so we're not yet seeing the rebalancing toward what they're talking about with the new reforms. The biggest concern is that they have a lot of credit imbalance—a big real estate price bubble. And this, I think, is going to have to be unwound in conjunction with some slower growth over time. So we're somewhat cautious overall in our outlook over the next year or two for China.
Schuster: What are you seeing in the United States?
Hofschire: The U.S. stock market is up a lot—not just this year, but over the past four or five years. So it does make sense, to temper our expectations, going forward. Valuations are higher than they were a year or two ago, and they're really not bad in terms of where we are.
Even though we have historical average valuations, I think you could say that valuations could go higher from here. We have low inflation, and that might help. We have improvement in investor sentiment toward stocks after shunning them for several years. But I think return expectations should be more in line with where earnings growth is going to go.
And we think profit margins can stay high. There's not a lot of wage pressure or commodity price pressures from many companies. But, as always, we can have a short‐term correction at any point, but who knows when that will come up? But I think if you have more muted expectations, there's still some upside, overall, from an asset allocation perspective. Equities still look OK to us.
Schuster: What are some of the things that you're looking out for in 2014?
Hofschire: When you look at what's happened in the markets since the global financial crisis, we've tended to have two main drivers of where market sentiment and returns have been moving. One is whether we are fluctuating up or down in the economic cycle. The other is policy decisions. We’ve had extraordinary monetary policies, and there are a lot of fiscal challenges in the world. I think the interplay between those two things is going to be critical in 2014 as well.
So, from the business cycle standpoint, I think things look largely favorable as we head into the year. The global cycles we've talked about in the past are getting modestly better, but they could grow more volatile as the year progresses. I don't necessarily think this volatility is going to come from the United States. We’ve got a pretty steady economic climate. We’re going to have less fiscal drag next year. We’ve got low inflation, but I do expect at some point the Federal Reserve is going to start to pare back on its quantitative easing. That might not be a huge problem for stocks in the U.S. It may not cause a big increase in interest rates, but it has tended to tighten liquidity conditions around the world. So that could affect emerging markets. It could even affect China, where I already have concerns.
There are other potential speed bumps along the way in places like Japan, where they're going to have an increase in consumption tax. We’ll see whether or not that's going to short-circuit the economic momentum they've had.
So when you put it all together, I think we will start the year with a decent overall economic backdrop. But it could be a bumpier ride for asset markets in 2014 as we go along. From an asset allocation standpoint, we’re going to tend to favor places that look a little steadier—and the U.S. might be one of those places.