December 20, 2013
Steady as she goes into the homestretch
By: Clayton M. Albright, III, Director of Asset Allocation
Wilmington Trust Investment Advisors
- Our Investment Strategy Team met this week and affirmed the weightings of our model asset allocation strategies, which serve as guideposts for long-term investors with diversified portfolios.
- We are heading into the homestretch of a remarkable year in which stocks have outperformed bonds by historically wide margins. We believe that the investment environment will continue to favor stocks over bonds, inflation hedges, and cash as we head into 2014.
- The Federal Reserve's decision to begin reducing its monthly bond purchases lessens market uncertainty and likely will lead to a wider recognition that economic conditions are improving. We expect interest rates—specifically, the yield of the 10-year U.S. Treasury note—to climb into the 3.0% range or higher by the middle of 2014, up from roughly 2.8% today.
- For the first time in a long time, our outlook is relatively free from concerns over financial crisis, systemic risks, and government ineptitude. However, we are keeping our eye on problems we see lurking below the surface.
Our Investment Strategy Team met this week and affirmed the weightings of our model asset allocation strategies.1 As depicted in Figure 1, we are overweighted, relative to our benchmarks, in equities. We are underweighted in fixed income securities—nominal bonds and cash equivalents combined. We are especially light on core bonds, such as U.S. Treasuries and investment-grade corporate and municipal debt. We continue to allocate to non-core bonds, such as speculative-grade floating-rate notes, and are overweighted in those assets by definition, because they are not included in our strategies' benchmarks. We retain our half-of-benchmark stakes—5% versus 10% in all strategies—in inflation hedges, which include inflation-linked bonds and commodity- and real estate-related securities.
So far 2013 has been a remarkable year for equity investors. Through November 30, 2013, the S&P 500 Index had outperformed the Barclays U.S. Aggregate Bond Index by 32.4%. Should the year end with this difference, it would mark the biggest historical differential going back to 1976. As we look to 2014, we expect that markets will continue to reward equity investors for a variety of reasons:
- We expect the global economic recovery to continue, despite the slowdown in emerging-market growth rates.
- Europe's economy, though still weak, appears to be stabilizing.
- The U.S. economy is likely to continue to grow more quickly, if slowly by historical norms, than most other developed economies.
- We have greater confidence in the U.S. recovery, in part because of the housing rebound.
- We expect U.S. GDP growth to accelerate to 2.5% or better in 2014, as the effects of U.S. fiscal drag decline while housing and business investment continue to increase.
- The Federal Reserve is likely to remain accommodative well into 2015 despite their decision this week to begin lowering their monthly bond purchases by $10 billion. We do not view "tapering" as equivalent to "tightening." Janet Yellen, current vice chairwoman of the Fed and presumptive successor to Ben Bernanke, has reinforced Bernanke's suggestions that the central bank's short-term interest rate target may remain near zero for some time after its bond-buying program has drawn to a close. This was reinforced by the Fed's decision to keep short rates low "well past reaching a 6.5% unemployment rate."
- We expect corporate earnings growth to continue to satisfy, though not overwhelm, investors.
- Our estimate of S&P 500 Index profits in 2014 is $116 per share, up from an estimated $109 per share this year. Our 2014 profit estimate is slightly conservative relative to the consensus forecasts of both top-down strategists and bottom-up company analysts ($118 and $122, respectively).
- We forecast that on September 30, 2014, the S&P 500 Index will be trading in a range of 1868–1988. The range reflects estimated price/expected earnings ratios of 15.5–16.5x and an earnings per share forecast of $120.50 for the 12 months ending September 30, 2015. Performance during 2013 has been largely driven by multiple expansion, but we expect next year's performance to be driven by earnings growth.
- As the Fed's tapering process evolves, we'd expect yields to rise further, thus hurting bond prices.
- The decision by the Federal Reserve to start decreasing their monthly bond purchases removes the uncertainty around the timing and magnitude of this expected policy change. Volatile markets may follow the decision but ultimately we expect investors to view the decision as positive for the economy and hence markets.
- We expect interest rates—specifically, the yield of the 10-year U.S. Treasury note—to climb into the 3.0% range or higher by the mid-2014, as the Fed begins to taper its asset purchases.
Looking ahead, our outlook for the first time in a long time is relatively clear of financial crisis, systemic risks, and government impasses. This supports our modestly optimistic view on economic growth, earnings increases, and market performance. However, we are also keeping a wary eye out for potential hazards that might not be part of our outlook now but should not be ignored:
- Interest rates could spike upwards and remain high. Such a rise likely would challenge the economy and cause capital markets to retreat. A spike in rates may reflect a decline in bond market liquidity, negative sentiment that builds upon itself, or concerns that the Fed does not have a strong handle implementing its policies.
- "Euro flu" strikes again, raising new questions over the viability of the single currency. Many of the underlying problems have not been solved, so further bouts of systemic angst are easy to imagine. High levels of unemployment remain, which could lead to social unrest. Systemic problems seem less likely to evolve from smaller "peripheral" countries, but larger countries such as Spain and Italy could still be a source of trouble.
- Corporate revenue growth has been modest, leaving earnings vulnerable to disappointment. Cost cutting may be difficult to implement if needed to offset disappointments in revenue generation.
- The administration could embark on government by regulatory fiat, bypassing Congress. Environmental, labor-related, and financial services regulations could be tightened, leading to decreased economic growth.
- "Income inequality" may be building as a political theme. Debate over the issue could once again raise the issue of tax increases for high-income individuals. Higher taxes and / or increases in the minimum wage could create headwinds for U.S. growth.
- The tapering of the Fed's bond purchases could set off problems for emerging economies, which then could spread and negatively impact global growth. Emerging economies' financial markets struggled this spring at the mere suggestion of reduced Fed support for the economy.
1 The construction of our model asset allocation strategies generally reflects a combination of asset-class valuation and momentum measures, overlaid by the judgment of our Investment Strategy Team. The extent to which—and speed with which—strategy-following client accounts reflect the Investment Strategy Team's models may vary, reflecting client-specific circumstances such as liquidity, tax sensitivity, and investment horizon.
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