Asset Management

After a strong 2013, markets look to the new year with cautious optimism

WILLIAM RIEGEL, HEAD OF EQUITY INVESTMENTS
LISA BLACK, HEAD OF GLOBAL PUBLIC FIXED-INCOME MARKETS

January 3, 2014

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U.S. and global equity markets finished 2013 strongly, albeit on very light trading volume. For the year as a whole, the S&P 500 Index advanced 32%, and the Russell 2000 Index (small-cap stocks) rose 39%. Based on MSCI indexes, foreign developed-market equities climbed 23% in 2013, led by Japan (+27%) and Europe (+25%). The MSCI Emerging Markets Index (-3% for the year) was a notable laggard.

Although many equity markets fell sharply on January 2, the first trading day of 2014, this was not unexpected. The S&P 500, for example, dropped more than 16 points (close to a 1% loss) on January 2, but the index had not seen a pullback of 10 or more points in over two weeks, so it was due for a downturn.

Article Highlights

  • Most equity markets had an excellent year, while investment-grade bonds posted losses.
  • In 2014, U.S. growth should remain solid, interest rates benign, and equity returns positive.
  • Markets in Europe, Japan, and China face unique issues that will bear watching.
  • The potential upside gain for stocks is likely far less than it was in 2013.
  • Increased equity volatility will highlight the traditional role of bonds as a core portfolio diversifier.

U.S. investment-grade fixed income markets, as measured by the Barclays U.S. Aggregate Bond Index, returned -2% in 2013, the first down year for the index since 1999. In contrast, the Barclays U.S. High Yield Bond Index returned over 7% for the year. The yield on the bellwether 10-year Treasury note closed at a two-year high of 3.04% on December 31 and stayed in the 3% range in the first two days of January. Fund flows remained positive for investment-grade and high-yield corporate bonds, and muted or negative for emerging-market and municipal bond funds, consistent with trends seen during the last half of 2013.

As 2014 began, fixed-income markets were seeking direction from various economic releases and potentially from remarks by several members of the Federal Reserve, including a scheduled January 3 speech by outgoing Fed chairman Ben Bernanke.

Current market updates are available here.

U.S. economic releases remain generally upbeat

Economic data released during the past week was mostly positive. Among the highlights:

  • Pending home sales rose 0.2% in November, the first uptick in six months.
  • Home prices were 13.6% higher in October versus a year ago—the strongest showing since February 2006—according to the S&P/Case-Shiller 20-city composite index.
  • Consumer confidence rebounded sharply, from 72 in November to 78.1 in December, according to The Conference Board.
  • Manufacturing activity remained strong in December, with separate purchasing managers indexes (PMIs) published by Markit Economics and the Institute for Supply Management registering 55 and 57, respectively. (Readings above 50 indicates expansion.)

For now, the accelerating pace of growth has not sparked fears of an overheating economy. This is in part because weekly unemployment claims remain higher than they should be given the level of economic growth, and surveys of housing market activity conducted by the International Strategy & Investment Group (ISI) have moved lower.

Despite strong 2013 equity returns, Europe faces some headwinds

European stocks finished behind the U.S. market but nonetheless advanced throughout the year and ended on a strong note. Moreover, at 52.7, Europe’s latest manufacturing PMI was in the expansion zone, with only France showing weakness.

One concern regarding Europe is that the euro looks suspiciously strong on a relative basis, having breached the critical level of 1.38 to the dollar. A further move up to and through 1.40 would present a significant headwind to European exports and overall economic activity.

Other indicators also warrant caution, as they are not conducive to growth:

  • Total bank loans in the region have contracted.
  • The European Central Bank’s (ECB’s) balance sheet continues to shrink.
  • Disinflation is becoming an issue, evidenced by extremely weak prices in Spain and Italy, where high unemployment and declining incomes continue to restrain consumer spending.

Japanese equity dynamics may be changing

Like Europe, Japan may also have issues with its currency, although of a different kind. In Japan, the straightforward dynamic of a weaker yen translating into a stronger stock market may have reached its limits. Many observers believe the yen has reached a zone of fair value (¥100 to ¥110 to the dollar, currently just north of ¥104). If the Bank of Japan were to weaken the yen to below the 110 level, it would trigger unwanted effects, such as much higher energy costs. Further weakening might also lead to unhappiness on the part of Japan’s trading partners. We tend to agree with this view and therefore believe that Japanese equities may trade in a volatile pattern in 2014, with only muted returns for the year.

China’s opaque economy and markets make it difficult to gauge prospects

Chinese equities, along with those of many other emerging markets, have been trading lower, in part due to weaker-than-expected PMI readings. China faces other challenges as well, including:

  • higher interest rates;
  • a stronger currency, which dampens exports;
  • potentially weaker housing prices;
  • slowing credit growth;
  • pressure on investment spending; and
  • distractions caused by the government’s anti-corruption campaign.

Although these factors are not particularly equity-friendly, much of the concern is already discounted in valuations of Chinese stocks. In fact, Asia (excluding Japan) is now among the cheapest equity markets in the world.

Overall, there is extremely divergent opinion about China, befitting its opaque economy and markets. China bears are very concerned about leverage in the system and the potential for a financial crisis, while China bulls are focused on policy reforms that they believe will deliver continued economic gains.

Outlook

We think economic growth in the U.S. will remain solid, interest rates benign, and equity returns positive in 2014. That said, the potential upside gain for stocks is likely far less than it was in 2013. We will also likely see greater volatility. The potential for increased equity volatility will highlight the traditional role of bonds as a core portfolio diversifier, although equities are likely to outperform bonds for 2014 as a whole.

A detailed 2014 outlook and forecast from TIAA-CREF’s chief economist Tim Hopper and global investment strategist Daniel Morris is available here.

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