A Look Back at 2013
Reflecting on 2013, Doll’s prediction of a “muddle-through” economy” and “grind-higher” equity market rang true for most market participants, with a number of the year’s challenges balanced by supportive policy actions and a more general reduction in market uncertainty. In a year where the federal government shut down for 16 days, a major U.S. city filed for bankruptcy, and the unemployment rate fell to a five-year low (as a result of modest job growth and a notable drop in the labor participation rate), economic growth was slow, but stable. Doll highlights that fiscal tightening brought about through both a significant tax increase and spending restraint (sequestration) cost the economy nearly 1.5% growth. Emerging markets lagged noticeably on weakness in global growth and commodity prices, and pockets of credit and liquidity problems.
Countering these trends, Doll points out that, “Monetary policy remained supportive of growth throughout the year and throughout the world. Europe began to emerge from recession, Japan benefitted from monetary and fiscal policy stimulus, and China appeared to have engineered a successful soft landing. In the United States, the year ended with an encouraging, albeit small, bipartisan deal to fund the government and replace the sequester with more sensible spending reductions.”
Despite global growth being softer than expected, equity markets performed very well, with the MSCI All Country Index increasing nearly 20% and the U.S. S&P 500 up nearly 30%. Equity valuation (P/E) expansion was a significant influence, perhaps because of reduced fear and uncertainty and rising confidence, factors that Doll notes, “should spill over into the economy in 2014.” Small stocks beat big stocks, cyclicals outperformed defensives, and growth and value performed about the same. Consumer discretionary, healthcare, and industrials were among the best sectors, with utilities and telecom lagging noticeably. Doll adds, “Ultimately, free cash flow was a powerful alpha generator.”
Key Themes for the Year Ahead
Set against this backdrop, Doll expects broader and stronger, but still moderate economic growth in the U.S. and globally in 2014. Doll sees the Federal Reserve’s approach to tapering as slow and incremental and as a result, expects bond yields to continue to rise gradually. Macroeconomic risks are diminishing as economies improve. Fiscal drag is lessening in the U.S., Europe is emerging from recession, Japan’s deflationary headwinds are lessening, and China is showing some signs of stabilization. Doll states, “In the U.S., better business sentiment on top of firming consumption will likely enhance the odds of a noticeable increase in capital spending enabling a somewhat stronger growth trajectory. The transition to self-sustaining growth will provide a much needed acceleration in revenue and earnings growth.”
Doll adds, “Skepticism about the durability of the equity rally remains widespread as many argue that stocks have become expensive and that profit margins are unsustainably high. We think those potential headwinds will limit, but not prevent gains, and perhaps cause more volatility than was experienced last year. While stocks are vulnerable to a correction any time given their recent strength and some technical deterioration, we continue to favor a moderate pro-growth posture with forward long-term potential to mid- to high- single-digit annual percentage gains. Within the equity market for 2014, we prefer companies with positive free cash flow profiles, low valuations, economic sensitivity and/or above average secular growth.”
With these themes in mind, Doll presents his 2014 Ten Predictions followed by his 2013 Scorecard.
1. The U.S. economy grows 3% as housing starts surpass one million and private employment hits an all-time high
After several false starts, the economic recovery which commenced in mid-2009 will likely show some broader and stronger growth in 2014. The litany of hopeful signs includes the housing recovery, falling oil prices, acceptable job growth, easing lending standards, low inflation, all-time high net worth, rising capital expenditures, less fiscal drag, and improving non-U.S. growth. Among other improvements, these forces should result in stronger housing starts and an all-time high in private employment.
2. 10-Year Treasury yields move toward 3.5% as the Federal Reserve completes tapering and holds short-term rate near zero
We expect the bear market in bonds that began some eighteen months ago to continue as interest rates slowly normalize. While the Fed will keep policy rates anchored close to zero, the long awaited tapering process will likely be completed during the course of 2014. A big question for the bond market, and for the economy and markets in general, is the inflation rate. While no significant rise in inflation is likely, it is also likely that that by the end of 2014, it will be clear inflation has made a bottom. Unfortunately, from this very low level of interest rates, not much capital depreciation in bonds caused by rising rates is required to offset coupon earned, causing many parts of the fixed income market to end 2014 with negative total rates of return.
3. U.S. equities record another good year despite enduring a 10% correction
On the back of very strong equity market performance in 2013, it is hard to conclude that equities haven’t “stolen” some 2014 returns. Accordingly, while we think equities will experience further upside in 2014, we expect gains to be less ebullient and more volatile. With the significant rise in valuation (P/E ratios) in 2013, we expect that market gains will depend more on earnings growth than further multiple expansion. While expectations of high single digit or low double-digit percentage gains are not unreasonable, we also think a noticeable pullback some time during the year is likely to be caused by overbought and deteriorating technical conditions. We would use pullbacks as buying opportunities as most fundamentals continue to improve.
4. Cyclical stocks outperform defensive stocks
After a long run of defensive stock leadership (consumer staples, healthcare, telecom, and utilities); cyclical stocks (consumer discretionary, energy, financials, industrials, technology and materials) asserted themselves early in the second quarter of 2013. For earnings and valuation reasons, we expect cyclicals to continue to outperform. Stronger U.S. economic growth, a rise in capital expectations, and some improvement in non-U.S. economies should be supportive of this conclusion as well. We find the geographic and size forecasts much more difficult since many cross-currents exist. We prefer free cash flow yield to dividend yield and dividend growth over dividend yield.
5. Dividends, stock buy-backs, capex, and M&A all increase at a double-digit rate
Corporate America has a lot of cash flow, and in many cases, underleveraged balance sheets – and, potentially, great places to use the cash. With some reduction of fear and uncertainty and improvement in confidence, we expect that more cash will be “put to work” in 2014. As a result, we think that dividends, share buy-backs, capital expenditures, and mergers and acquisitions will experience noticeable increases in 2014. Dividends and buy-backs have been increasing in recent years, but we expect the largesse to spread to businesses reinvestment (capex) and buying the company “down the street.” Pent-up demand and aging of plant, equipment and technology argue for increases in those key areas.
6. The U.S. dollar appreciates as U.S. energy and manufacturing trends continue to improve
Currency direction is one of the most difficult areas in the capital markets to get right. Along with improved and broadened growth, as well as technical support, we believe the developing U.S. energy and manufacturing stories are dollar positive. Due to an abundance of cheap natural gas and increasing energy production, U.S. energy is already providing a positive impact on the U.S. trade deficit and promises to enhance U.S. job additions and economic growth. The increasing desire by U.S. and non-U.S. companies to manufacture in the United States for labor, cost, infrastructure, and stability reasons has a similar salutary dollar impact.
7. Gold falls for the second year and commodity prices languish
In our opinion, the mystery is not that gold finally came down – the mystery is that it took so long. The preoccupation with gold was originally related to a concern about the viability of the financial system, and the concern about inflation with so much money being “thrown” at this system. As neither of those circumstances occurred, gold still traded above $1,500 per ounce for some time before falling last year. Now the added headwinds of improving global growth and a reduction in systemic threats, some rise in real interest rates, and likely dollar improvement, all put further pressure on gold’s allure. In addition, the lack of strong global economic growth and abundant supply for many commodities likely argues for trendless, but volatile (as usual) commodity prices.
8. Municipal bonds, led by high yield, outperform taxable bond counterparts
Municipal bond mutual funds experienced a record number of weeks of outflow in the back part of 2013. And while fundamentals are arguably mixed, our contention is that the pricing of municipal securities relative to taxable fixed income securities more than take that into account. While rising interest rates (prediction #2) create a headwind for fixed income, we believe the tax-exempt market, especially high yield tax-exempt, is positioned for outperformance. The visibility of Detroit’s and Puerto Rico’s difficulties has created an interesting opportunity for municipal bond investors. We believe the fall of 2013 was a turning point for state and local governments as politicians and unions have begun to agree to some reduced pension benefits. Additionally, state and local government receipt and outlay patterns are improving.
9. Active managers outperform index funds
Recent years have been disappointing for active manager’s ability to outperform benchmarks. With the broadening of the equity market and the reductions of correlations, the ability of active managers to outperform can increase. Whether or not the percentage of outperforms crosses 50% is a debatable issue, but the fundamental support for that outcome seems to be increasing. As cheap stocks outperform expensive ones and companies with improving fundamentals outperform companies with deteriorating fundamentals, active managers have a better chance to outperform. Further, a reduction in the number of active players perhaps reduces the competitive landscape somewhat as well.
10. Republicans increase their lead in the House but fall short of capturing the Senate
In 2013, Washington, D.C. proved to be front and center often and with mixed consequences. We believe that a dovish Fed and a declining federal budget deficit make the Washington backdrop for investors at worst benign, and more likely constructive. The recently negotiated “small ball” deal between Democrat Patty Murray and Republican Paul Ryan will likely reduce the negative focus on fiscal policy. The November mid-term elections will soon dominate Washington with the likelihood of Republicans slightly increasing their lead in the House of Representatives, and increasing representation, but failing to control the Senate. Other dominating issues will likely include the improved economic outlook, continued fiscal restraint, Obamacare, and the loss of global prestige.
Grading 2013’s Predictions
1. The U.S. economy continues to muddle through with nominal growth below 5% for the seventh year in a row
Correct
2. Europe begins to exit recession by the end of year as the ECB eases and financial stresses lessen
Correct
3. The U.S. yield curve steepens as financial risks recede and deflationary threats lessen
Correct
4. U.S. stocks record a new all-time high as stocks advance for the fifth year in a row
Correct
5. Emerging market equities outperform developed market equities
Incorrect
6. After two years of underperformance, U.S. multinationals outperform domestically focused companies
Correct
7. Large-cap stocks outperform small-cap stocks and cyclical companies outperform defensive companies
Half-Correct
8. Dividends increase at a double-digit rate as payout ratios rise
Correct
9. A nascent U.S. manufacturing renaissance continues, powered by cheap natural gas
Correct
10. The U.S. government passes a $2–3 trillion ten-year budget deal
Incorrect
Total Score: 7.5 out of 10
For more detailed information on Bob Doll’s 2014 Ten Predictions including full commentary and a point-by-point examination of his 2013 predictions, visit www.Nuveen.com/ten-predictions. To learn more about Nuveen Asset Management’s Large Cap Equity Series managed by Bob Doll, visit http://www.nuveen.com/MutualFunds/LCES/Large-Cap-Equity-Series.aspx. Financial advisors interested in receiving Doll’s weekly commentary and special market reports can subscribe via the following link: http://nuveen.com/weekly-commentary. Follow Bob Doll on Twitter via https://twitter.com/BobDollNuveen.
About Nuveen Asset Management
Nuveen Asset Management offers a broad range of innovative investment strategies, from traditional and specialized equity to taxable and municipal fixed income. With solutions that span multiple asset classes, the firm’s disciplined approach to equity and fixed income investing is driven by integrated research and risk management processes. Nuveen Asset Management offers a collaborative approach to multi-strategy portfolio management that emphasizes quality and ingenuity. Nuveen Asset Management managed approximately $118 billion as of September 30, 2013. For more information, please visit the Nuveen Investments website at www.nuveen.com.
About Nuveen Investments
Nuveen Investments provides high-quality investment services designed to help secure the long-term goals of institutional and individual investors as well as the consultants and financial advisors who serve them. Nuveen Investments markets a wide range of specialized investment solutions which provide investors access to capabilities of its high-quality boutique investment affiliates—Nuveen Asset Management, LLC, Symphony Asset Management LLC, NWQ Investment Management Company, LLC, Santa Barbara Asset Management, LLC, Tradewinds Global Investors, LLC, Winslow Capital Management, LLC and Gresham Investment Management LLC all of which are registered investment advisers and subsidiaries of Nuveen Investments, Inc. In total, Nuveen Investments managed $215 billion as of September 30, 2012. For more information, please visit the Nuveen Investments website at www.nuveen.com.
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The views and opinions expressed are for informational and educational purposes only as of the date of writing and may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-investment-grade bonds involve heightened credit risk, liquidity risk, and potential for default. Foreign investing involves additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. Past performance is no guarantee of future results.