We expect the U.S. economy to accelerate into a bit higher gear in 2014 and grow at a 2.5% – 3% rate, up from the approximately 1.7% that we expect for full year 2013. Many of the headwinds that have been holding back growth are receding. Households have deleveraged, resulting in a trimming of debt service. Additionally, higher housing prices and the robust stock market of the past two years have boosted consumers’ sense of wealth. The fiscal drag, both taxes and sequestration, of 2013 is likely to diminish in 2014 and an improving jobs picture should help on both the discretionary income and sentiment fronts. Our outlook for commodity prices remains benign, creating no energy tax on consumers in the near future. Combined, these factors should be instrumental in driving the U.S. economy forward in 2014.
The Eurozone emerged from recession over the summer of 2013, and we see the recovering progressing, albeit, at a sluggish pace. Policy actions ranging from the ECB’s pledge to buy bonds from struggling sovereigns, to their accommodative monetary stance, to their retraction of severe austerity programs that had been imposed on economies in recession all support the recovery. However, the Eurozone continues to struggle with fragile and uneven economic healing due to the region’s lack of banking and fiscal integration. Much deeper structural reforms are needed for the Eurozone to regain pre-crisis GDP per capita levels and make significant inroads into its staggering unemployment levels. But even modest economic growth in 2014 will help those economies that export into the Eurozone and add to the overall global GDP pick-up that we see for the year.
We also continue to remain in the “soft landing” camp for China. Although much has been written over the last couple of years indicating that China could experience severe financial issues based on the rapid credit growth in the country, we continue to believe that given China’s strong centralized government structure and the very low level of central government debt relative to GDP that China can manage through its issues. China should be helped somewhat by slightly improving economies in the United States, Europe and Japan, although most of their economic growth will be driven domestically. It should also be remembered that “slower” growth in China is still in the 6% to 8% range. Also, although Brazil, India and Russia continue to have structural political and economic issues, we believe that these economies will also improve slightly in 2014.
We believe the implication of the upcoming confirmation of Janet Yellen as Fed Chairperson is that monetary policy will be very supportive of economic expansion for at least the next couple of years. With inflation below the Fed’s target and the labor market being far from full employment, both parts of the Fed’s dual mandate support stimulative monetary policy. This is not in conflict with our view that the Fed will begin to taper its stimulus by mid-year 2014. We’ve often expressed our opinion that the shrinking U.S. deficit means that QE3 is effectively financing nearly 150% of our deficit up from 100% when it was put in place and that the Fed’s hand will eventually be forced into pulling back on its bond purchases. We think that the time is nearly upon us. But Yellen has noted that there are no economic thresholds that are automatic triggers for true tightening. Her comments lead us to believe that the Fed may hold the Federal funds rate effectively at zero even after the unemployment rate hits 6.5% and that the Fed will emphasize that the initial taper of quantitative easing should not be interpreted as a leading indicator of any early rise in the Federal funds rate.
Based on our outlook for slightly accelerating global economic growth, continued easy money policies from the Fed, ECB and the BoJ, and benign inflation, 2014 should be another positive year for risk assets. Valuations have expanded sufficiently over the past two years that we don’t anticipate returns to match the lofty double digits of 2012 and 2013. Rather, we expect price performance on the S&P 500 to match or slightly exceed the mid-single digit growth that we expect in operating earnings.
We feel strongly that stocks have not become overvalued when measured on P/Es as well as on an array of other metrics. Given the historically low interest rate environment that we expect to persist through 2014 into 2015, we anticipate that P/E multiples could even expand somewhat from current levels, leading to high single digit total returns for stocks.
History shows that you can’t determine how long a bull market will run based on time alone. Post WWII bull markets have varied from two to nine years in length and the dispersion is quite high. The duration and returns of bull markets are better determined by the interest rate and growth backdrop, the magnitude of the downturn prior to the bull market and valuations, rather than by arbitrary time periods. In our current five-year market recovery, leadership has come primarily from early cycle sectors like consumption and housing plays. We would expect to see some rotation in market leadership as the bull cycle continues leading to P/E multiple expansion in sectors that have lagged.
Although the three-decade secular bull cycle in bonds is likely over, we expect rates to remain at the low end of their historic range. We anticipate the 10-year Treasury rate to rise to over 3% in 2014 as the economy gains some steam, but we don’t see rates surpassing the 3.5% level. We’ve seen a significant rise in rates in 2013, much of which has been driven by the fear of anticipated Fed action rather than the underlying fundamentals of credit demand. In our view, rates have already significantly discounted the tapering policy that we expect the Fed to initiate by mid-year. Thus, we see 2014 as a year of rather moderate rate rise and one where we have the potential to see very low single digit positive total returns from bonds.