Sun Breaks Through the Clouds

One lasting legacy of the Great Recession is our pre-occupation with concerns about new crises that will lead to a reprise of that terrible period. 2013 was chock full of crises that were supposed to derail us. We started off with the fiscal cliff (sooo 2012…) which gave rise to surprisingly positive new tax laws. Then came the sequester, the chemical weapons crisis in Syria, the debt ceiling showdown and the government shutdown. Let’s not forget China’s growth slowdown and the launch of Obamacare. And lurking in the background was the imminent demise of the Eurozone and the common currency! All of these bogey men turned out to be not so scary and the US stock market not only shrugged them off but surged to new all time highs.

The biggest surprises of the year turned out to be Fed “taper talk” – first came the too-early discussion of it by Chairman Bernanke in May and June. While shocking the bond market, equity markets barely flinched. And then there was the big “nevermind” in September and the bond market rallied while the stock market just kept plugging along. Finally, the Fed closed out the year with a modest start to tapering its asset purchases, setting the stage for the new Chair to implement it. How ironic that the one entity trying to prop up markets gets the credit for creating the most volatility!

As we look forward to 2014, there aren’t even any faux crises on the horizon to be worried about. Even Congress, the best at creating crises out of thin air, decided to patch up their budget differences before the holidays, leaving no real fiscal accidents waiting to happen in 2014. It is amazing how forthcoming elections can focus the mind!

Of course there are lingering concerns in Europe, Japan, China and other emerging markets. But after six years of prospective crises, we find ourselves a bit uncomfortable with a moderately sunny outlook.

How Sunny Is It?

Let’s not get too excited. While the outlook is improving, it is hardly perfect. Here in the US, the employment picture continues to show resilience as the jobs reports have shown consistent, if uninspiring, strength. Stock market gains and home price increases have restored consumers’ net worth to pre-2008 levels, while debt service costs have dropped to a very low percentage of income. We are seeing this positive backdrop show up in solid gains in retail sales and strength in automobile sales. Housing continues to recover but a sharp back up in rates could well slow that recovery.

We expect that this consistent growth path will lead the Federal Reserve to wind down its bond purchase program in 2014. This will likely be coupled with repeated statements about holding short term rates low. That long term interest rates have stayed as low as they have might be a bit surprising. We think this is a function of low and contained inflation. Without labor cost pressures, we expect inflation to stay low for some time to come. The ten year Treasury bond yield was in a range of 2.50-3.0% for the second half of 2013. Over the course of 2014, we expect that range to move up to 3-3.5%.

But we also expect volatility in rates to be the norm as markets try to figure out how the Fed moves away from its bond purchases. It is certainly possible that long term rates could move up much farther and faster than anyone expects, tanking the bond, stock and real estate markets all at the same time.

Still Cloudier to the East

In Europe, we are now past the German elections so we would hope to see continued progress toward solidifying a Eurozone bank regulator. Austerity and, more importantly, labor and tax reforms in southern Europe are finally beginning to have an impact on those economies. But we are hardly out of the woods. While the recession has technically ended, growth is very anemic and there is a real risk of backsliding into another recession.

Much further east, Japan’s Abenomics program is having the desired short term impact: modest growth and inflation. However, big challenges lie ahead. For progress to be sustained, fundamental changes need to take place in the labor market. Companies need the flexibility to hire and fire according to market needs, rather than providing lifelong employment. And workers need to be rewarded for increased productivity so that sustained growth in wages can take hold. Finally, there is an enormous demographic problem building which will likely require new approaches to immigration and labor rules. Progress on these difficult structural issues is by no means assured.

And Just Plain Hazy in China

Meanwhile, China, the bigger growth engine of Asia, has completed its leadership transition and the Third Plenum. Billed in advance as reforms comparable in importance to those of the late 1970s, the high level plans that came out of the Plenum are important evolutionary steps. Whether they turn out to be revolutionary will depend on the implementation. Loosening of the one child policy, changes in land rights for farmers, reform of the household registration system and a definitive statement that market forces should guide resource allocation are just some of the key provisions of this new plan.

While we view these changes as quite positive, they will take some time to play out. In the meantime, China is still burdened by an economy too-dependent on fixed investment, financial and labor imbalances and strong state-owned enterprises. Perhaps most important for long term investors, China’s new leaders understand the problems they face and have crafted a plan to deal with them.

Other major emerging markets face issues unique to their own situations. One common thread is high inflation and low growth, a combination not likely to inspire investors’ confidence for some time. Relatively cheap stock prices in these markets reflect these poor fundamentals.

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to new dynamics.