06-25-2014 12:22 PM
Looking at the U.S. economy and investment markets, the first half of 2014 was as notable for what didn’t happen as for what did.
Some of the things that did occur in the first six months of the year:
- Economic growth. After a series of fits and starts, due at least in part to one of the harshest winters in recent memory, the U.S. economy appears to finally be on a sustainable albeit somewhat slow growth track. The pace of job creation has picked up, as have consumer confidence and manufacturing.
- Reduced QE. The economic gains convinced the Federal Reserve that it was safe to begin a long-awaited tapering of its $85 billion in monthly bond-buying, known as quantitative easing. By June, monthly QE had been reduced to $35 billion a month, with the expectation that the program would be shrunk to zero before year-end.
- Bulls ran the market. Wall Street marked its fifth year in the current bull market, pushing confidently into a sixth year of gains. The Standard & Poor’s 500 index posted more than a dozen record closes in the second quarter, and as of mid-June, it was up 4.8 percent for the year.
And a few things that surprisingly didn’t happen:
- Interest rate growth. A clear consensus called for interest rates to start climbing after the Fed began tapering its QE program, but after four incremental cuts to QE, the 10-year Treasury note’s yield had fallen from 3 percent at the beginning of the year to around 2.6 percent by mid-June.
- Drop in bond prices. Given their inverse relationship, a forecast of higher yields implicitly predicts lower bond prices. Once the Fed announced its QE taper, many investors quickly sold bond holdings to get clear of the risk. But in the first half of 2014, the 10-year Treasury has seen its strongest start to a year since 2011.
- High volatility. The near-absence of volatility in the second half of 2013 was supposed to give way to bigger and more frequent swings as the stock market climbed higher and the impact of monetary tightening took hold. Conditions, however, have been fairly placid.
Of course, there’s no guarantee that the happenings in the first half won’t reverse in the second half of the year. While we at USAA take a long-term view as investors, we would like to share some of our thoughts on how we see the rest of 2014 shaping up.
We think GDP growth will be decent in the second half, though it will likely fall short of the 3 percent-plus growth expectations at the beginning of the year. We are also not sure how sturdy the recovery is. Much has been made of the effects of an exceptionally cold winter in explaining the 2.9 percent contraction in GDP in the first quarter, but we are not totally convinced that the weather alone is to blame. We are watching closely to see how the economy fares during more moderate conditions.
Three rounds of QE by the Fed since 2010 have been aimed at accelerating tepid economic growth, but as Figure 1 shows, each time the Fed starts dialing back QE, deflationary forces push bond yields down and bond prices up. We suspect this may indicate that the economy has not yet strengthened to the point where growth is sustainable without monetary help from the Fed. We have long believed that, while interest rates will rise over the longer term, this rise would be far more gradual than the market was expecting. This notion of “lower for longer” leads back to what we’re seeing in the economy. The Great Recession of 2007-09 was a “balance-sheet recession” caused by excessive debt burdens carried by individuals, companies and governments. Recovery from balance-sheet recessions tends to be slow and fragile, and this recovery fits that model. As a result, rates should remain low in the second half, barring an unforeseen event that alters expectations.
ASSET CLASS OUTLOOK
U.S. equities: The tendency is to assume that a healthy economy is good for stocks and not so good for bonds, but that direct relationship doesn’t always hold true. Proof of such decoupling can be seen between 2009 and 2013, when the stock market was soaring and the economy was scuffling. Stock prices have outpaced economic fundamentals, so the long-term question for U.S. equities is, “Can the improving economy generate the revenue growth needed to justify today’s high valuations and serve as a foundation for future price gains?” That question, however, doesn’t have to be answered in the short term. The series of record S&P 500 finishes in the second quarter has been met by a notable lack of enthusiasm or anxiety, the latter reflected in the CBOE Volatility Index (VIX), also called the “fear gauge.” Figure 2 shows the VIX at one of its lowest levels in more than two decades, which suggests the market is not particularly worried about a reversal at this point. While we are underweight U.S. stocks due to valuation concerns, the current complacency could continue to carry stocks upward in the second half.
Stock market volatility is running low
U.S. fixed income: Demand for bonds has been high even with the ongoing cuts to QE by the Fed, with Treasuries hitting a high for the year in May. Long-dated Treasuries, in fact, have posted their highest return in two decades and have significantly outperformed high-yield corporate bonds. We don’t expect too much more of a rally in Treasury prices, provided there is no significant economic surprise or disappointment. While we anticipate that interest rates will remain very low for quite some time, we are nonetheless prepared for rising rates by underweighting Treasuries and maintaining a focus on select investment-grade credit and high-yield, both of which have outperformed in rising-rate environments. Investor expectations should be more modest when compared to recent years, with the effect of rising rates offset by the combination of current yield and reinvestment of principal at higher rates. A supply-demand imbalance in the municipal bond market has been a key contributor to strong gains in the first half. We expect that imbalance to endure for the rest of the year and even into 2015.
International equities: Based on fundamental valuation, we like non-U.S. stocks compared to U.S. stocks. As you can see in Figure 3, the eurozone’s ratio of current price to average earnings over the past five years (yellow line) has recovered from recent lows in 2012, but it is still well below both its long-term average and the current valuation for the S&P 500. In developed Europe, GDP growth is still slower than in the U.S., but the European Central Bank seems determined to use monetary easing to boost growth and reduce the eurozone’s deflationary risks. The European Central Bank has so far focused on interest rate cuts while resisting a call for a QE program of its own, but it has made clear that QE remains an option if necessary to stimulate growth. The enduring strength of the euro is a major headwind facing the eurozone economy, as it has both reduced the demand for European exports and held inflation below desired levels.
Overseas valuations are more attractive than U.S. valuations
Emerging markets: We continue to see long-term opportunity in emerging markets, where GDP growth should continue to outpace the countries of the developed world. In fact, we are starting to increase our overweight to select emerging markets due to attractive valuations. Figure 3 shows that long-term P/E rose quickly from the depths during the global recession but have since dipped back down again. 2014 started rough for emerging markets, but since bottoming out in early February, they are up by double digits. Growth is accelerating in many countries (China is an exception), and a QE move by the EU could provide a liquidity boost.
While this outlook extends to the remainder of 2014, it’s important to stress that the next six months are only a small window of time. As long-term, global investors, we look across the entire business cycle when positioning our portfolios. We urge our members to also focus on the long term and on global opportunities when making their investment decisions. Geopolitical events can cause increases in short-term market volatility, which can present a chance for well-prepared, long-term investors to rebalance their portfolios at better prices.
Past performance is no guarantee of future results.
As interest rates rise, existing bond prices fall.
This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.
Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable
The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.
Financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License # 0E36312), and USAA Financial Advisors, Inc., a registered broker dealer.