12-17-2013 12:09 PM
The Top Line
• 2013 was a great year for equity markets that will be hard to repeat in 2014.
• We foresee continued modest GDP gains in the U.S. and Europe. The pace of growth in emerging markets is expected to slow, but still should be faster than growth in developed countries.
• We expect the Federal Reserve to begin to taper its asset purchase program in 2014 if its economic growth estimates are achieved.
• Interest rates should continue their gradual ascent over the next several years along with an improving economy, which will benefit a well-diversified portfolio. In fixed income, we favor segments of the bond market that are more sensitive to credit risk than interest-rate risk.
• We continue to focus on global diversification. We will head into 2014 with overweights in emerging market equities and inflation-linked assets and a slight underweight to the U.S. stock market.
2013 Market Review
The Standard & Poor’s 500 index, up more than 27% through Dec. 11 (Figure 1), hit a series of record highs during 2013, while the Dow Jones industrial average shattered through the 16,000 mark late in the year and the Nasdaq Composite surpassed 4,000 for the first time since the tech boom in 2000. In addition, the Russell 2000 Index of small-cap stocks was up more than 31%. Despite lower economic growth, stock markets in developed nations significantly outpaced those in emerging markets in 2013. International stocks in developed markets lagged in comparison to the U.S., but still gained a more-than-respectable 18%, with Japan (+43% in local currency) being the standout.
Figure 1: 2013 Performance by Asset Group
2013 PERFORMANCE (Through Dec. 11)
|Large U.S. Stocks||S&P 500||+ 28.37%|
|Small U.S. Stocks||Russell 2000||+ 31.81%|
|International Stocks||MSCI EAFE||+ 18.96%|
|Emerging Markets||MSCI Emerging Markets||- 02.49%|
|Treasury Bond||10-Year U.S. Treasury||- 06.71%|
|General Bond||Barclays U.S. Aggregate Bond||- 01.76%|
|Tax-Exempt Bonds||Barclays Municipal Bond||- 02.51%|
|High-Yield Bonds||Barclays U.S. Corporate High Yield||+ 07.13%|
|Gold||Dow Jones-UBS Sub-Index||- 25.44%|
2013 was essentially the tale of two markets. Earlier in the year, some risk assets that generally do well in periods of rising inflation were unsettled by Federal Reserve Chairman Ben Bernanke’s comments that the Fed might soon begin to taper its $85 billion monthly bond purchases, commonly referred to in the press as quantitative easing or “QE.” Figure 2 depicts how the performance of emerging markets and Treasury bonds fell off after taper talk began, and how their relative performance versus U.S. large caps dramatically widened. Emerging markets bounced back some in the second half of the year but continued to underperform as slowing GDP growth, rising inflation and softer commodity prices weighed on results.
Figure 2: Following the Taper Talk in May, Emerging Markets and Treasury Bonds Have Lagged U.S. Equities
The strong performance in equity markets, and in risk markets in general, can largely be explained by investors’ willingness to take more risk to escape the unusually low yields created by the Fed. This “reach for yield” started in the bond market but quickly moved to other asset classes. This caused prices to increase faster than fundamentals and earnings growth would imply. As a result, valuations increased and accounted for the majority of equity gains for the year (Figure 3). The price-earnings ratio for U.S. small-cap stocks, for example, jumped 25% in 2013. In Europe, the P/E ratio rose 20%, and U.S. large caps increased nearly 18%. Emerging markets’ P/E, on the other hand, slipped about 2%.
Figure 3: Changes in Valuation Multiples Have Accounted for a Majority of Price Returns in 2013
Looking Ahead to 2014
With a healthier housing market, improving corporate profits and lower unemployment rates, we believe the economy is strengthening, albeit slowly. We forecast that real GDP in the U.S. will grow by about 2.5% in 2014, up from the 1.7% currently estimated for 2013. Faster growth in the developed world should bode well for emerging markets, whose export-led economies tend to perform better when global growth expectations are rising.
However, the jobs picture has been particularly vexing, and our concern is that it may not be as strong as the headline number indicates. While the headline unemployment rate is falling, much of the decline can be explained by a falling participation rate. It’s true that the economy is creating new jobs, but a large proportion of them are in lower-paying service industries. For more robust growth, we are looking for gains in areas like manufacturing, which has recently had sluggish growth.
Nevertheless, we believe the Fed has enough ammunition to begin winding down its QE program in 2014. When the taper starts, we believe it will be very gradual so as not to upend the economic gains of the past four-plus years. In any event, short-term interest rates are expected to stay close to zero in the near term. In fact, the Fed hopes the markets will like its promise of “low rates for longer” more than it dislikes the taper. That being said, if the taper were to significantly disrupt financial markets, the Fed would likely modify its approach.
We see the best market opportunities in 2014 in emerging markets. They lagged in 2013 as taper talk ramped up, GDP growth rates slowed in China and other large emerging market nations, and corporate profits weakened. The pace of economic growth, however, remains well ahead of developed markets, and equity valuations in emerging markets are significantly more attractive.
How should investors react to news coming out of Washington?
We caution investors against adjusting their portfolios based on political events that will likely prove to have at most only a short-term impact on markets. Resist any temptation to abandon your long-term investment plan because the market probably won’t remember these events in three to five years – remember that many of those who went to cash during the 2007-08 financial crisis and stayed there have missed out on a stellar recovery that has taken U.S. markets to new all-time highs.
What is the outlook for U.S. stocks?
It will certainly be a challenge for U.S. stock markets to have a better year in 2014 than they did in 2013, given the succession of record highs seen late in the year. In our view, equities are trading at fairly rich valuations during a period of modest earnings growth. In each of the first three quarters of 2013, year over year earnings growth has ebbed to the mid-single digits, well off the double-digit pace consistently seen since 2009. In early December, the average forward P/E ratio for companies in the S&P 500 was 15x (Figure 4), up more than 15% from end of 2012 and above the 10-year mean of 14x. We don’t think we are in bubble territory, but we are watchful heading into the new year given this year’s market run-up.
Figure 4: P/E Ratios Appear Slightly Overvalued in the US Relative to Their 10-Year Average
Our concerns over valuation are amplified when we consider the impact of revenue growth and margins on future U.S. corporate earnings. In recent years earnings have been bolstered by cost controls and improved productivity. Faster GDP growth could lift revenue, but that might be accompanied by higher wages that would threaten margins from the cost side. Therefore, maintaining today’s above average profit margins (Figure 5) may be difficult.
Figure 5: Margins in the US are Near All-Time Highs, While Europe and Emerging Markets Have Room to Rise
We acknowledge that equity prices could keep climbing even deeper into record territory. In that event, our cautious view on current valuations based on fundamentals could leave us out of step in a momentum-driven market.
While we have a tactical view to be slightly underweight U.S. equities overall, within the asset class we prefer companies that pay and grow their dividends. Companies with strong balance sheets and attractive fundamentals are also likely to outperform, particularly in an inflationary environment. USAA funds that benefit from this strategy include the USAA Income Stock Fund and the USAA Real Return Fund.
Where are international markets headed?
Some have forecast that Europe is embarked on a period of negligible annual GDP growth – akin to Japan’s “lost decade” following the late 1990s bust – but we believe such a view may be overly pessimistic. The European Commission estimates 1.4% GDP growth in the EU next year, rising to 1.9% in 2015, with domestic demand as the key growth driver.
We spent much of the first half of 2013 with a slight underweight to European equities due to worries about the potential fallout from a financial crisis in Cyprus, but as the year has progressed, we have increased our position. Valuations in Europe look attractive relative to the U.S., particularly when measuring cyclically adjusted earnings (Figure 6), which look at a more normalized and longer-term earnings stream than a standard price to earnings ratio.
Figure 6: European Equities Appear Undervalued Relative to the US on Cyclically Adjusted Valuation Measures
Additionally, we see positive macroeconomic signs coming out of Europe – among other measures, labor productivity, business confidence and consumer confidence have all risen during the year (Figure 7).
Figure 7: Leading Indicators in Europe Have Turned Higher
Looking ahead to 2014 and beyond, we feel emerging markets may offer more attractive valuations than developed markets, and that these valuations adequately compensate us for the economic risks. The forward P/E ratio for the MSCI Emerging Markets Index is just over 10x, compared to 13.5x for the MSCI EAFE and 15x for the S&P 500. We are particularly constructive on those countries where there is a pronounced demographic shift from rural to urban, and where the middle-class population is expanding. Additionally, despite GDP estimates coming down for emerging economies, they are expected to remain higher than those in developed markets (figure 8).
Figure 8: Emerging Economies are Expected to Grow at Higher Rates than Advanced Economies
The USAA International Fund and USAA USAA World Growth Fund both represent vehicles to access the non-U.S. developed equity markets, while the USAA Emerging Markets Fund offers a way to access developing markets.
Should investors stay exposed to bonds?
The short answer to this question is “Yes”.
In our view, gradually rising interest rates will go hand in hand with an improving economy which should benefit a well-diversified portfolio. However, if rates go up quickly, it will signal that the Fed made an error in its prolonged easy-money policy and inflation concerns could reemerge. If rates stay at current levels or fall, it will signal that the economy’s problems are more intractable than expected and that recessionary conditions could return.
The choice for investors to make as interest rates rise is not as simple as either owning bonds or not owning bonds. It is important to remember that it is a market of bonds and not a bond market. We believe that the breadth of the bond market offers a continuum of risk and return characteristics that may appeal to a range of investors, depending on their investment objectives.
In our bond portfolios, we are tilting more toward credit risk than interest rate risk. This positioning leads us to prefer asset-backed securities and corporate bonds, including high-yield issues, over Treasury bonds. Yields for Treasuries have climbed this year, but they still languish just above all-time lows (Figure 9), which heightens the risk of loss if interest rates continue to rise. On the other hand, cheap borrowing costs have helped reduce default rates for high-yield bonds to low levels.
Figure 9: Long-Term Interest Rates Remain Very Low
Focusing on credit-sensitive areas of the market and maintaining shorter duration has enabled our bond portfolios to outperform our peers, and we believe that in 2014 our fixed income assets will again be positioned to outperform.
On the taxable side, our credit-oriented fixed income strategy is available in the USAA Intermediate-Term Bond Fund and the USAA High Income Fund. Among municipals, consider the USAA Tax Exempt Intermediate-Term Fund.
Should Investors prepare for an upturn in inflation?
The short answer to this question is “Yes”.
The length and the magnitude of the Fed’s monetary stimulus program has, in our view, significantly elevated inflation risk in the coming years. As a result, we will enter 2014 with an overweight to inflation-linked assets, specifically gold-mining equities.
Current inflation in the U.S. is running low – the 2013 Consumer Price Index is up only about 1% year over year through the end of November (Figure 10). In Europe, inflation has been less than 1% for the year.
Figure 10: Inflation Pressures Remain Extremely Low
The prices of gold and gold-mining equities, which tend to reflect inflation worries, were especially hard hit in 2013 as investors showed less interest in using gold or mining companies as a hedge against rising prices or a weakening dollar. We are, however, maintaining our overweight position in gold-related equities as a hedge against potential inflation and currency devaluation. The large increase in their balance sheet assets (Figure 11) has put key central banks on a tightrope -- a major monetary policy mistake on their part could lead to higher-than-expected inflation.
Figure 11: Central Bank Balance Sheets Remain Elevated
In addition, we think gold-mining stocks are attractively valued based on their business fundamentals. The gold selloff through most of 2013 may present an opportunity for investors to gain inflation protection for their portfolios at a lower cost.
The USAA Precious Metals and Minerals Fund offers a means of investing in this sector in a way that diversifies into metals beyond gold.
The Bottom Line
At USAA, we construct and manage investment portfolios that strive to achieve superior performance over a full market cycle while adhering to the highest ethical standards. That means above all doing the right thing for our members and clients.
As active managers, we believe markets are often inefficient. We endeavor to take advantage of mispriced assets and seek long-term returns that compensate investors for their assumed risks. We adhere to our disciplined, team-oriented research and portfolio construction process, even if it causes us to deviate from the Wall Street consensus.
Heading into 2014, our foremost fixed income focus will be on rising interest rates and their potential impact, while on the equity side, we will be paying the most attention to fundamentals and valuations in the U.S. and overseas as we work to uncover the most promising opportunities for our investors.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for you based upon your individual goals, objectives, risk tolerance, and time horizon.
Consistent with that focus, we are concerned that many of our members may still be holding too much of their portfolio in bonds and cash. Members with well-diversified portfolios should consider positioning themselves to help insulate their portfolios from the impacts of sharply rising interest rates. Such adjustments could include modest allocation shifts between bonds and stocks, as well as moves to diversify bond holdings. One example could involve shifting part of a position in Treasuries to investment-grade corporate bonds. The additional yield provided by corporate bonds can help cushion against the impact of rising rates.
Cash levels should be kept at levels appropriate for an investor’s time horizon. Cash in an emergency fund or for an upcoming expense should be held in a safe, highly liquid investment vehicle. Investors with excess cash on the sideline which is earmarked for longer-term goals, might consider seeking higher yields while they wait for better investment opportunities. The USAA Ultra Short-Term Bond Fund, the USAA Short-Term Bond Fund and the USAA Tax-Exempt Short-Term Bond Fund could fit this purpose.
USAA offers a number of ways for members to tap into the strategies developed by our investment management team within a single vehicle, including our asset allocation funds or, for a more tax-managed approach, the USAA Managed Portfolios. These vehicles, which provide asset allocations that vary by member risk tolerance and objective, all focus on diversification, which we believe is essential for most investors but is often overlooked when portfolios are constructed.
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.
Consider the investment objectives, risks, charges and expenses of the USAA mutual funds carefully before investing. Contact us at 1-800-531-8910 for a prospectus containing this and other information about the funds from USAA Investment Management Company, Distributor. Read it carefully before investing.
Investing in securities products involves risk, including possible loss of principal.
Past performance is no guarantee of future results.
As interest rates rise, existing bond prices fall.
Non-investment grade securities are considered speculative and are subject to significant credit risk. They are sometimes referred to as junk bonds since they represent a greater risk of default than more creditworthy investment-grade securities.
Some income may be subject to state or local taxes or the federal alternative minimum tax.
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.
Precious metals and minerals is a volatile asset class and is subject to additional risks, such as currency fluctuation, market liquidity, political instability and increased price volatility. It may be more volatile than other asset classes that diversify across many industries and companies.
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.
USAA or its affiliates do not provide tax advice. Taxpayers should seek advice based upon their own particular circumstances from an independent tax advisor.
High double digit returns are attributable, in part, to unusually favorable market conditions and may not be repeated or consistently achieved in the future.
Financial planning services and financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License #0E36312), a registered investment adviser and insurance agency and its wholly owned subsidiary, USAA Financial Advisors, Inc., a registered broker dealer.
Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.
Managed Accounts is a service of USAA Investment Management Company (USAA), a registered investment adviser and broker dealer
The Real Return Fund may be subject to stock market risk and is non-diversified which means that it may invest a greater percentage of its assets in a single issuer. Individual stocks will fluctuate in response to the activities of individual companies, general market, and economic conditions domestically and abroad. When redeemed or sold, may be worth more or less than the original cost.
The Ultra Short Term Bond Fund is subject to various risks including Real Estate Investment Trusts (REIT), Exchange Traded Funds (ETFs), and derivative risk. Investing in REITs may subject the Fund to many of the same risks associated with the direct ownership of real estate. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks. The derivative risk is that it is not well correlated with the security, index, or currency to which it relates. Investment returns may fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
Diversification does not guarantee a profit or prevent a loss.